I recently overheard two men at breakfast chatting about life in retirement. When their conversation turned to inflation, my interest was piqued. The exchange was short, but memorable.
“I read today that it’s at 4.1%!” said the first man.
“Yeah, but if you look at it since a few years ago, they say it’s more like 14% … So, really, they can make it anything they want by fiddling with the numbers,” his friend said.
It was all I could do to bite my tongue and refrain from bounding over to their table with a resounding, “Well, actually …” Instead, like the mature and polite person I sometimes am, I left them to their meal and their misconceptions.
These two men are not alone in their misunderstanding of inflation and the effect of compounding over time. Quite likely you have many clients who are similarly baffled by such numbers, but don’t want to ask questions that might make them appear ignorant. However, since inflation is once again making headlines, it seems like an opportune time to address how we can talk about compounding in a way that’s relatable and simple to understand.
COMPOUNDING WORKS BOTH WAYS
Advisers are used to teaching clients about the miracle of compounding interest when explaining the benefits of long-term investing, but less attention seems to be given to explaining the eroding power of inflation when planning for the long term. Yes, we build it into our models and we mention to clients that forecasts are “adjusted for inflation,” but without an explicit and clear explanation, most people have no idea what that really means.
I think this is a real problem. By glossing over or failing to adequately explain how inflation, compounded over time, significantly reduces our spending power, we leave people vulnerable to the false assumption that the income they have today will still be adequate in 10 or 20 years. This is especially dangerous for people living on fixed incomes.
So how do we talk about cost-of-living increases in a way that’s simple and memorable? I personally like to use stories and the Rule of 72.
The greatest teachers throughout history have used stories to make their points more memorable. When it comes to inflation, I like to tell stories about hamburgers: Remember how your grandparents used to talk about buying a burger for a quarter? Now a $2 fast-food burger is cheap. That isn’t a 700% inflation rate. It’s a 3% inflation rate, compounded over 75 years.
Put as simply as possible, at 3% inflation, prices double every 25 years. That means that after 25 years, the hamburger cost 50 cents. Then, after another 25 years, it doubled again to $1, and after a total of 75 years, it doubled again to $2. We can use the Rule of 72 to play around with different rates and doubling times, but I find it’s simpler for many people to conceptualize prices doubling, and then doubling again, rather than trying to accurately visualize annual compounding.
This idea of prices doubling over time helps explain why we aim for our investments to outpace inflation in the first place, and it can help you motivate clients to keep growth in mind even after they transition from accumulation to decumulation.
It’s difficult to explain inflation-adjusted growth, but much more straightforward to say, “Since prices double roughly ever 25 years, then if you plan to be in retirement for 25 years, you’ll need to plan for prices to double during that time. Let’s talk about how we can do that by keeping your portfolio growing while you’re in retirement.”
Sarah Newcomb is a behavioral economist at Morningstar Inc.
As our second lead editor, Cindy Hamilton covers health, fitness and other wellness topics. She is also instrumental in making sure the content on the site is clear and accurate for our readers. Cindy received a BA and an MA from NYU.