What is the fixed income squeeze?

Avoiding the Fixed-Income Squeeze

We have all seen those sad letters.  Yes, those letters to the editor where a senior citizen is complaining that their property taxes are going up a few percent and they are extremely worried that they can no longer afford their own home.  The home where they raised three children.  Where they experienced many fond memories of birthdays, graduations and family reunions.  Where there are tiny handprints in the cement under the basketball pole.  Their cherished home that is now in jeopardy because the cost of living is beginning to put pressure on their budget.

Over time, inflation has averaged around three percent per year.  Three percent doesn't seem like much, does it?  After all, that's just a few pennies out of a dollar.   But, whether you think about it or not, inflation slowly chips away at the spending power of your savings and investments.  You need your retirement nest egg to increase by more than the rate of inflation each year.  It needs to increase by at least three percent after you have taken an income to live on.  

Think back to the first house you ever purchased.  What did you pay for it?  Can you remember how many years ago that was?  What would it take to buy that same home today?  That's the effect of inflation.  In fact, there is a good chance that a new car today will cost more than your original house. 

If you're at the beginning of your retirement, you'll need your nest egg to last longer than the time that has passed between now and the purchase of that first house.  Many retirements are lasting twenty and even thirty years.  You need the wealth you've accumulated for retirement to grow faster than inflation. 

I contend that the inflation rate that senior citizens experience is higher than the inflation rate of the general population.  During retirement your medical costs will consume a greater portion of your budget than at any other time in your life.  The rising cost of medical care seems to have no limit and thus the cost of living for seniors is very volatile.

Many people enter their retirement feeling that they have a good plan.  Their projected income from Social Security, pensions and investments looks like it will exceed what they believe they need to live on.  If your income is projected at $5,000 a month and your expenses are projected at $4,000 a month you might feel safe and secure.  However, there is a chance that you are not and you will wake up one day to a nasty surprise.

Whether you are safe or not has a lot to do with the quality of your income.  Many pensions do not increase with time, or like Social Security, they do go up a little each year but not at the rate that seniors need to keep up with their true inflation rate.   Slowly but surely they begin to work themselves into a dead-end trap.  First, the new property tax assessment arrives; then, gasoline prices go up; you're hit with an unanticipated medical expense; your kids need a little extra cash to get through a tough spot...you get the picture.  Your expenses go up faster than your income and soon you have a real problem.  What once looked like a safe and secure retirement has now turned into a terrible nightmare. 

This whole situation could be avoided if people understood the real rate of return they are making on their investments.   Let's look at a simple example of the difference between what you think you are making and what your real rate of return is.  Assuming you had $100,000 to invest and that Certificates of Deposits are paying 5%: 

The interest you earn at 5%	$5,000
Less your federal and state taxes @ 25%	($1,250)
Less your loss of buying power with 3% inflation.	($3,000)
Earnings left for you - Real Rate of Return	$75

The interest you think you are earning is called your "Gross Return" or your perceived return.  This is the one that you pay taxes on.  You get a nice warm feeling watching your account go up every year.  The money left over after paying your taxes and accounting for inflation is your "Real Rate of Return".  Inflation is deceptive because you don't take out your checkbook and pay for it directly.  But, it's exactly as if you had.  Your money buys less and less every year. 

To be fair, history tells us that the "Gross Return" shown in the example above could be higher or lower.  Interest rates change all the time.  But it's also important to note that the "Gross Return" moves in direct response to the level of inflation.  When the "Gross Return" goes up so does the cost of inflation and, consequently, so do your taxes. The end result is that your "Real Rate of Return" is usually about the same, not much more than zero.

Do you remember 1980?  Certificate of Deposit rates were over 16%.  People tell me every day they wish they could earn that kind of money on safe investments again.  Wasn't that a great time.....?  No! It wasn't.  Inflation was running as high as 14%!  Let's run our simple equation again with the 1980 numbers:

The interest you earn at 16%	$16,000
Less your federal and state taxes @ 25%	($4,000)
Less your loss of buying power with 14% inflation.	($14,000)
Earnings left for you - Real Rate of Return	($2,000)

You were losing money, even at 16% and the sad part is people did not even know it.

No wonder more and more people are just getting by these days.  Even folks with big nest eggs find that planning for a successful retirement can be a real challenge.  It's easy to get into hot water and not even know it. 

Here is where most people entering retirement make a big mistake.

They say to themselves, "I'm retired.  I can no longer earn a living so it's time to be conservative."  I agree it is time to be more conservative, but you still need your nest egg to grow at a rate equal to the inflation rate plus the amount you want to spend.  For most people, their money needs to grow at a rate higher than the rate that is paid on Certificates of Deposit.  They need their money to grow at 6%, 7% or even 10%. 

If you want to spend 5% of your nest egg every year, you will need to earn at least 8%, and that's not even paying for the taxes due.  One of the ways to earn this type of return is by building a fundamentally sound and diversified portfolio of stocks and bonds.  Yes there is some risk, but "risk" is not a four letter word.  Okay, maybe it is, but at least you don't have to wash your mouth out with soap for using "risk".  Please get a copy of my book, 18 Common Sense Rules for Enjoying a Successful Retirement, and read about risk in Chapter 4.   Or, attend one of my seminars where I'll show you solid ways to control risk.

You can think of risk like fire.

If you refuse to use fire you have to eat raw food. 

If you don't respect fire you will get your fingers burned.

But properly used in a controlled environment, you can use fire to cook your supper and enjoy your meal.

It is extremely important to have a professional run your retirement numbers for you to make sure your investment plans and your spending plans dovetail together to provide you with a successful and carefree retirement.  Isn't that why they call them "the golden years"? 

I use the most powerful retirement projection software available that examines how your nest egg will perform under a variety of situations.  I look at optimistic projections as well as negative projections in an attempt to find a balance where you can realize your retirement dreams and protect yourself from experiencing the dreaded fixed-income squeeze.

Finding the right balance during retirement is one of the keys to living a successful retirement.  You want to understand what the fixed income squeeze is and protect yourself from a nasty surprise someday.  But you can't live your retirement in fear and save everything for tomorrow.  Understanding how your portfolio can work for your benefit and protect you at the same time will allow you to truly enjoy your golden years.

Give me a call if you would like to discuss your retirement.  Take the time to "run the numbers" on your personal situation to find out what your best options are.

Ron Dickinson, CPA, CFP, MPA-tax.

712-328-2600

"Turning your retirement dreams into reality through proven, time tested investment solutions."