There is no doubt that inflation is running through the entire economy. However, the strange thing is that the interest you can earn through CDs and money market funds has nowhere to go. This is called financial repression, and it makes retirement difficult.
The interesting thing about financial repression is that it was designed by the Federal Reserve. The Fed consciously pushes up inflation and keeps interest rates low. This means that the price of everything you need will rise, but the interest you can pay for these things will not.
In the previous economic cycle, we were not financially restrained. For example, in the 1970s, when the inflation rate was 10%, CD paid about 10%. Therefore, investors can at least maintain a balance. But today, this is a completely different story. The financial repression scenario began after the 2008 financial crisis. Today’s gap is the largest in history, with an inflation rate of 5% and short-term interest rates close to 0%.
Although inflation may fall, the suppression may continue, which means that interest rates will remain below the inflation rate. For example, if the inflation rate is 3% and the short-term interest rate is still close to 0%, then 15 years later, in terms of purchasing power, you will lose about half of your wealth.
How can retired investors deal with this repression? Well, you can write to your congressman or senator and tell them to end financial repression, but I don’t think it will do any good. The reality is that the United States will continue to have huge deficits. To make up for these deficits, our government needs to keep interest rates low. But at the same time, they also want to increase inflation, thereby generating more taxes. The combination of low interest rates and high inflation makes it easier to bear larger deficits, which is why the Fed and most of our elected leaders like financial repression.
If there are no changes in federal policy, you will face the basic choice of losing the purchasing power of wealth or investing more aggressively every year. While it can be scary to invest more aggressively during retirement, as inflation eats up your savings, it can be just as scary to run out of funds. In order to invest more actively, you must consider the possibility of long-term losses. For many couples, retirement is a 30-year cycle, and you must keep this time frame in mind.
As I mentioned above, if your income is 3% lower than inflation in just 15 years, you will lose about 50% of your purchasing power. But if you invest more money in the stock market, how likely is it that you will lose money in 15 years? It should be very small. Historically, the stock market represented by the S&P 500 has never experienced a 15-year negative cycle. Although there are no guarantees, based on what we have learned from history, it is reasonable to assume that the probability of loss is less than 5%.
When assessing risks in financial markets, it is also important to look at it in perspective compared to other risks in your life. We drive, fly, ride bicycles, and eat food with warning labels. The reality is that we have to endure various risks, and investment risk is just one of them. The best thing you can do is to make rational judgments based on the trade-off between risk and reward.
Given the financial repression we face, let us look at the basic trade-off between being too conservative and being more aggressive. In short, if you are too conservative, you may lose wealth in the long run, and if you are more active, you are more likely to accumulate wealth. Therefore, I will allocate more money to build wealth. Not all, but more.
There is no simple answer, but my guess is that many retirees will not actively invest to outweigh the damage caused by financial repression. A proverb said this many years ago: To figure out how many stocks you should invest in, you subtract your age from 100. This is the number of stocks you invest in. Therefore, if you are 65 years old, that means you will invest 35% of stocks. This used to be a good suggestion when you can earn more income from a fixed income. But today, this type of retirement may not be enough to offset the long-term effects of financial repression.
Charlie Farrell is a partner and managing director in the Denver office of Beacon Pointe Advisors. This article is for reference and educational purposes only. Past performance does not guarantee future returns, and all investments involve permanent risk of loss. Please consult your personal financial advisor for guidance specific to your situation.