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Yesterday’s post described the difficulty of figuring your tax bracket. It mentioned the concept of hidden tax brackets—places where the Tax Code causes you to lose a tax goody because of additional income, resulting in an effective marginal tax rate that’s way higher than what the published tables would have you believe. I thought it would be informative to provide an example.
Informative, yes. Useful, no. Because the intricacies of how these hidden brackets work make it difficult to predict them or plan around them. With that disclaimer, read on.
Example. George is single. He earns $55,000 in 2009 working for the New York Yankees, where he’s covered by a pension plan. George contributes $5,000 to a traditional individual retirement account. And that $5,000 is deductible, as explained in February 14’s post. George’s federal income tax works out to $6,350, after taking into account his IRA deduction, personal exemption and standard deduction. And he’s solidly ensconced in the 25% federal tax bracket.
Lucky George! The Yankees pay him an unexpected year-end bonus of $10,000! George guesses he’ll owe $2,500 federal tax on his year-end bonus because he’s in the 25% bracket. Wrong as usual, George! George is gob-smacked by a nasty hidden tax bracket. The extra $10,000 of income causes him to lose his $5,000 IRA deduction (again, see February 14’s post). Which in turn causes him to pay tax on $15,000 of income rather than $10,000. At his nominal 25% tax bracket, that’s $3,750 of tax. So his actual hidden tax bracket on the $10,000 bonus is 37.5%.
That’s a pretty high tax rate for a poor schlep like George, who’s not even the CEO of a failing bank.
Showing posts with label Financial Projections. Show all posts
Showing posts with label Financial Projections. Show all posts
Thursday, February 26, 2009
Wednesday, February 25, 2009
A Word or Two About Tax Rates
Yesterday’s post and a number of prior posts somewhat facilely refer to your tax bracket—both current and future. Just what do I mean by tax bracket? It's time to enter that heart of darkness.
When you are trying to decide between two retirement planning strategies—how much to save, how much to spend, to Roth or not to Roth, which savings bucket to spend first, in which savings bucket to house your stocks, etc.—it often becomes necessary to guess at, and compare, your marginal tax brackets. “Marginal” means the tax bracket affecting your top dollar of income, rather than the average tax rate on all of your income. They’re not the same because we have a progressive tax system.
(A brief aside: “Progressive” means the tax rate gets higher as your income increases, as with the federal income tax. “Regressive” means the rate gets lower as your income increases, as with the Social Security tax [6.2% on the first $106,800 of compensation, 0% on the rest]. But these words are really loaded. “Progressive” sounds so modern, advanced and forward-thinking. “Regressive” sounds like you’re a troglodyte. But no value judgments are intended. The words just describe how the rates vary with the thing that's taxed, income in this case.)
Example. Mary is single and earns $150,000 as a TV news producer. She uses the standard deduction, and claims just herself as a personal exemption. Her 2009 federal income tax totals $33,102, so her overall average tax rate is 22%. But her marginal tax bracket increases with each tranche of income. The first slice of $9,350 of income is taxed at 0% (representing her personal exemption and standard deduction). The next $8,350 is taxed at 10%; then $25,600 at 15%; $48,300 at 25%; and the balance ($58,400) at 28%. Mary’s marginal tax bracket is 28%. So any moves she makes—to reduce or increase her taxed income—either saves or increases her tax by 28%. Sort of. Read on.
Often things are not so simple. Here are some of the complications you’ll run into as you try to figure your marginal tax rate.
• Crossing brackets. A big move might cause you to shift—up or down—from one bracket to the next. So some of your income is at one marginal tax bracket and some at a different one. For example, converting a large traditional IRA to a Roth IRA can easily cause you to straddle two brackets.
• Alternative Minimum Tax. If you have large deductions that are classified as “tax preferences” (such as state and local taxes) then you might be paying Alternative Minimum Taxes, in which case your marginal tax bracket becomes 26% or 28% regardless of what the regular tax rate tables say.
• State income tax. If your state has an income tax, your marginal state tax rate should be added to your marginal federal tax rate to figure your effective tax bracket. In our example, Mary lives in Minnesota, and figures her marginal state tax rate is 7.85%, making her total marginal tax bracket 35.85%.
• Effect of state tax on federal income tax. If Mary itemizes her deductions, then her state tax reduces her federal tax. So her effective marginal tax bracket would then be 33.65%. Unless she’s paying Alternative Minimum Tax. Oy.
• Hidden tax brackets. The federal tax code is just full of hidden tax brackets. Various tax deductions , credits and other such goodies are available only to those with lower income, and then get phased out for those with higher income. If you are within these phase-out ranges—which vary from one goodie to the next—then you are actually subject to a higher hidden tax bracket, as you lose the benefit of a deduction or credit. Gotcha!
• Capital gains. Some income—notably long-term capital gain—is subject to favorable tax treatment, resulting in a lower tax bracket for that type of income.
The message here is that it’s massively complex just figuring what tax bracket you’re in today, even after you’ve completed your tax return. And so what about projecting your bracket 20 years into the future? Forget about precision. Just take your best shot at an educated guess.
The horror; the horror!
When you are trying to decide between two retirement planning strategies—how much to save, how much to spend, to Roth or not to Roth, which savings bucket to spend first, in which savings bucket to house your stocks, etc.—it often becomes necessary to guess at, and compare, your marginal tax brackets. “Marginal” means the tax bracket affecting your top dollar of income, rather than the average tax rate on all of your income. They’re not the same because we have a progressive tax system.
(A brief aside: “Progressive” means the tax rate gets higher as your income increases, as with the federal income tax. “Regressive” means the rate gets lower as your income increases, as with the Social Security tax [6.2% on the first $106,800 of compensation, 0% on the rest]. But these words are really loaded. “Progressive” sounds so modern, advanced and forward-thinking. “Regressive” sounds like you’re a troglodyte. But no value judgments are intended. The words just describe how the rates vary with the thing that's taxed, income in this case.)
Example. Mary is single and earns $150,000 as a TV news producer. She uses the standard deduction, and claims just herself as a personal exemption. Her 2009 federal income tax totals $33,102, so her overall average tax rate is 22%. But her marginal tax bracket increases with each tranche of income. The first slice of $9,350 of income is taxed at 0% (representing her personal exemption and standard deduction). The next $8,350 is taxed at 10%; then $25,600 at 15%; $48,300 at 25%; and the balance ($58,400) at 28%. Mary’s marginal tax bracket is 28%. So any moves she makes—to reduce or increase her taxed income—either saves or increases her tax by 28%. Sort of. Read on.
Often things are not so simple. Here are some of the complications you’ll run into as you try to figure your marginal tax rate.
• Crossing brackets. A big move might cause you to shift—up or down—from one bracket to the next. So some of your income is at one marginal tax bracket and some at a different one. For example, converting a large traditional IRA to a Roth IRA can easily cause you to straddle two brackets.
• Alternative Minimum Tax. If you have large deductions that are classified as “tax preferences” (such as state and local taxes) then you might be paying Alternative Minimum Taxes, in which case your marginal tax bracket becomes 26% or 28% regardless of what the regular tax rate tables say.
• State income tax. If your state has an income tax, your marginal state tax rate should be added to your marginal federal tax rate to figure your effective tax bracket. In our example, Mary lives in Minnesota, and figures her marginal state tax rate is 7.85%, making her total marginal tax bracket 35.85%.
• Effect of state tax on federal income tax. If Mary itemizes her deductions, then her state tax reduces her federal tax. So her effective marginal tax bracket would then be 33.65%. Unless she’s paying Alternative Minimum Tax. Oy.
• Hidden tax brackets. The federal tax code is just full of hidden tax brackets. Various tax deductions , credits and other such goodies are available only to those with lower income, and then get phased out for those with higher income. If you are within these phase-out ranges—which vary from one goodie to the next—then you are actually subject to a higher hidden tax bracket, as you lose the benefit of a deduction or credit. Gotcha!
• Capital gains. Some income—notably long-term capital gain—is subject to favorable tax treatment, resulting in a lower tax bracket for that type of income.
The message here is that it’s massively complex just figuring what tax bracket you’re in today, even after you’ve completed your tax return. And so what about projecting your bracket 20 years into the future? Forget about precision. Just take your best shot at an educated guess.
The horror; the horror!
Monday, February 16, 2009
Investment Expenses
A little bit of cost control can pay off big time in the long run.
There are lots of administrative costs to investing, and if you can find ways to shave them just a little bit—without sacrificing the quality of advice that often comes with them—you can painlessly improve your future retirement security.
Here’s a quick example. Patty starts saving $10,000 per year at age 40 in some kind of tax-favored retirement plan. The annual administrative expense built into the plan is 0.4% of her assets. Using some reasonable assumptions, Patty figures as a result of her saving, she can expect retirement spending of $28,325 per year, beginning at age 65. Her cousin Cathy is identical to Patty, same age, savings, etc. Except that Cathy has lived most everywhere, and is a bit smarter than Patty. (In fact, she’s a bit of a Little Miss Smarty Pants.) Anyway, she manages to cut her administrative expenses by one-tenth of a percentage point (aka, 10 basis points, in financial world jargon) to 0.3%. Cathy projects annual spending of $29,067, which represents a 2.6% increase over Patty’s.
Admittedly, a 2.6% increase is not huge. Enhancing your retirement spending by a small amount like that is not a great idea. But it’s a modestly good idea. And when melded with all the other modestly good ideas available to you, it adds up. Anyway, it’s better than a headache.
What kind of administrative expenses are you incurring that might be eroding your savings? There’s lots of them: investment advisor fees, asset custodian fees, account maintenance fees, brokerage commissions, accounting expenses. If your account is inside an employer retirement plan, there are other fees as well: trustee fees, recordkeeping fees, accounting fees, legal fees. The list goes on. Some of these fees may be picked up by your employer, and others may be charged to your account.
Some of these fees may be disclosed, and some hidden. Often all you will ever see on your statement is the net return (or loss, of late) for the quarter, with no explicit statement of what size fee got you down to that net. Some services may be bundled, making it difficult to break out how much you’re paying for what service.
Sometimes there are fees layered upon fees. For example, your 401(k) plan may be invested in mutual funds. There may be some fees charged by the plan, and other fees charged by the mutual fund.
The more you can learn about the fees that erode your account, the better able you will be to find ways to shave them, to intelligently assess which fees are appropriate for the value added, and which can be shrunk without damage to your overall wellbeing.
That’s the theory anyway.
There are lots of administrative costs to investing, and if you can find ways to shave them just a little bit—without sacrificing the quality of advice that often comes with them—you can painlessly improve your future retirement security.
Here’s a quick example. Patty starts saving $10,000 per year at age 40 in some kind of tax-favored retirement plan. The annual administrative expense built into the plan is 0.4% of her assets. Using some reasonable assumptions, Patty figures as a result of her saving, she can expect retirement spending of $28,325 per year, beginning at age 65. Her cousin Cathy is identical to Patty, same age, savings, etc. Except that Cathy has lived most everywhere, and is a bit smarter than Patty. (In fact, she’s a bit of a Little Miss Smarty Pants.) Anyway, she manages to cut her administrative expenses by one-tenth of a percentage point (aka, 10 basis points, in financial world jargon) to 0.3%. Cathy projects annual spending of $29,067, which represents a 2.6% increase over Patty’s.
Admittedly, a 2.6% increase is not huge. Enhancing your retirement spending by a small amount like that is not a great idea. But it’s a modestly good idea. And when melded with all the other modestly good ideas available to you, it adds up. Anyway, it’s better than a headache.
What kind of administrative expenses are you incurring that might be eroding your savings? There’s lots of them: investment advisor fees, asset custodian fees, account maintenance fees, brokerage commissions, accounting expenses. If your account is inside an employer retirement plan, there are other fees as well: trustee fees, recordkeeping fees, accounting fees, legal fees. The list goes on. Some of these fees may be picked up by your employer, and others may be charged to your account.
Some of these fees may be disclosed, and some hidden. Often all you will ever see on your statement is the net return (or loss, of late) for the quarter, with no explicit statement of what size fee got you down to that net. Some services may be bundled, making it difficult to break out how much you’re paying for what service.
Sometimes there are fees layered upon fees. For example, your 401(k) plan may be invested in mutual funds. There may be some fees charged by the plan, and other fees charged by the mutual fund.
The more you can learn about the fees that erode your account, the better able you will be to find ways to shave them, to intelligently assess which fees are appropriate for the value added, and which can be shrunk without damage to your overall wellbeing.
That’s the theory anyway.
Tuesday, February 3, 2009
Pre-Tax vs. After-Tax Returns
In January 30’s post I showed how the most valuable feature of tax-favored retirement plans is their tax exemption, compared to investing inside ordinary taxable investment accounts. How do you assess that value as you weigh the pros and cons of contributing to a tax-favored retirement plans? The two most important factors influencing that value are: (i) time (how long before you must distribute dollars from the plan?), and (ii) return differential (what is the difference between your pre-tax rate of return and your after-tax rate of return?). In today’s post I want to give some thought to the second factor.
In the example in January 28’s post, Ralph and Ed were in the 30% tax bracket during their working years. I asked you to assume that their investments earned 7%, but that Ed’s investment returns, being outside the shelter of a retirement plan, were shaved down to 5.3%. Where did that come from?
Wouldn’t it be better to assume that if Ed is in the 30% tax bracket, his investment income would be shaved by 2.1 percentage points (= 30% x 7%), down to 4.9%? No, Kemosabe, it would not. Why not? I’m glad you asked.
Shaving Ed’s return by his tax rate would be accurate enough if all of Ed’s investments were in the form of taxable bonds and other interest-bearing investments. But how likely is that? It’s more likely to be invested in a mixture of asset classes, with more complicated tax treatment. Consider all these complications:
• To the extent invested in municipal bonds, the appropriate differential is determined by the difference in interest rates between taxable and municipal bonds, as dictated by the financial markets and not Ed’s tax bracket at all.
• To the extent invested in stocks, a big component of Ed’s expected return is appreciation in value, which is not taxed at all until there’s a sale of the stock.
• When there’s a sale of appreciated stock, that appreciation is turned into capital gain, and Ed will have to pay tax on that gain. But the Feds give us a break and impose a lower tax rate than Ed’s 30% if the gain is long-term (i.e., the stock was held more than a year). Currently the federal rate is 15% or lower. That huge break may not hold for very long, but it’s a safe bet that long-term capital gain will continue to receive some sort of favorable treatment.
• And capital gain is very lumpy. It’s realized in chunks as Ed chooses to sell appreciated stock, unlike interest and dividends, which are taxed smoothly as they accrue. With capital gain, you can easily end up with a big tax bill in a money-losing year simply because that’s the year you choose to sell and reap prior years' appreciation.
• Under current tax law, built-in appreciation that has not been realized (by a sale of the stock) disappears at death and doesn’t get taxed at all. Well, actually the appreciation doesn’t disappear—just the taxation of it. (That particular rule is scheduled to change in 2010, but I have a feeling Congress and Obama will opt to retain the existing rule when it acts to reinstate the federal estate tax.)
• Currently, dividends are taxed at a preferential rate, like long-term capital gain, which is another complicating factor. Although it does not seem likely that will continue beyond 2010.
So if you invest a portion of your taxable account in anything other than taxable bonds, it is likely that your after-tax investment return will be somewhat greater than the number you would get by simply reducing your pre-tax rate of return by your tax rate. There will be some remaining differential, however, and that will be a big factor in determining the benefit you can expect from housing your savings in a tax-favored retirement account.
In the example in January 28’s post, Ralph and Ed were in the 30% tax bracket during their working years. I asked you to assume that their investments earned 7%, but that Ed’s investment returns, being outside the shelter of a retirement plan, were shaved down to 5.3%. Where did that come from?
Wouldn’t it be better to assume that if Ed is in the 30% tax bracket, his investment income would be shaved by 2.1 percentage points (= 30% x 7%), down to 4.9%? No, Kemosabe, it would not. Why not? I’m glad you asked.
Shaving Ed’s return by his tax rate would be accurate enough if all of Ed’s investments were in the form of taxable bonds and other interest-bearing investments. But how likely is that? It’s more likely to be invested in a mixture of asset classes, with more complicated tax treatment. Consider all these complications:
• To the extent invested in municipal bonds, the appropriate differential is determined by the difference in interest rates between taxable and municipal bonds, as dictated by the financial markets and not Ed’s tax bracket at all.
• To the extent invested in stocks, a big component of Ed’s expected return is appreciation in value, which is not taxed at all until there’s a sale of the stock.
• When there’s a sale of appreciated stock, that appreciation is turned into capital gain, and Ed will have to pay tax on that gain. But the Feds give us a break and impose a lower tax rate than Ed’s 30% if the gain is long-term (i.e., the stock was held more than a year). Currently the federal rate is 15% or lower. That huge break may not hold for very long, but it’s a safe bet that long-term capital gain will continue to receive some sort of favorable treatment.
• And capital gain is very lumpy. It’s realized in chunks as Ed chooses to sell appreciated stock, unlike interest and dividends, which are taxed smoothly as they accrue. With capital gain, you can easily end up with a big tax bill in a money-losing year simply because that’s the year you choose to sell and reap prior years' appreciation.
• Under current tax law, built-in appreciation that has not been realized (by a sale of the stock) disappears at death and doesn’t get taxed at all. Well, actually the appreciation doesn’t disappear—just the taxation of it. (That particular rule is scheduled to change in 2010, but I have a feeling Congress and Obama will opt to retain the existing rule when it acts to reinstate the federal estate tax.)
• Currently, dividends are taxed at a preferential rate, like long-term capital gain, which is another complicating factor. Although it does not seem likely that will continue beyond 2010.
So if you invest a portion of your taxable account in anything other than taxable bonds, it is likely that your after-tax investment return will be somewhat greater than the number you would get by simply reducing your pre-tax rate of return by your tax rate. There will be some remaining differential, however, and that will be a big factor in determining the benefit you can expect from housing your savings in a tax-favored retirement account.
Monday, February 2, 2009
Projections, Predictions, Assumptions
Yesterday’s post talked about the need to do a new projection every year as a way of constantly adjusting your planning to reality. Makes sense. But . . . what’s a projection? Here’s the transcript of an actual recorded conversation between Kwai Chang Caine and Master Po.
Caine: “What’s a projection, Master Po?”
Po: “It’s an educated guess about the future, Grasshopper”
“And do I get this guess from a Magic Eightball? Or from the wind?”
“No, Grasshopper, it’s an educated guess. No fingers in the wind. You start with the facts—the things that are real. To that you add assumptions about the future—how long you will live, what your investments will earn, how much your salary will be—such things as that.”
“So these assumptions, they are my predictions for the future?”
“No! No predictions! We are Shaolin priests, not charlatan fortune tellers!”
“Thank you for correcting me, Master. I am humbled by your wisdom. And where do these assumptions come from?”
“You must glean them from the world as you see it. You can take them from history. Or from indicators if you like. Or from reputable experts. Whatever source is rational and readily at hand.”
“Can I take them from different sources in different years?”
“Bad idea, Grasshopper. That is a prescription for fooling yourself. And a Shaolin priest, above all else, never fools himself. Try to avoid switching sources. Be consistent in the source for each of your assumptions”
“So this annual prediction . . . no, projection . . . it is my educated guess as to the most probable outcome for the future?”
“Close, Grasshopper. Not the most probable. But rather, the expected outcome. The probable center of all possible outcomes.”
“I think I understand, Master. But I must ask one more question if I may.”
“Knock yourself out, Grasshopper.”
“You said I could find reasonable assumptions from history if I choose, such as average returns on stocks or bonds. But Master Kan has taught me that history is no predictor of the future. So how is that a reasonable basis for making a projection? Or projecting an expected outcome?”
“That’s a tough one. We Shaolin masters think long term. And we believe that certain historical long-term tendencies are likely to reassert themselves in the long-term future.”
“That still sounds like double-talk to me. No disrespect intended, Master.”
“Shaolin masters do not engage in double-talk, Grasshopper. Now go out and preach the ways of peace. And beat up some bad guys with your stick.”
Caine: “What’s a projection, Master Po?”
Po: “It’s an educated guess about the future, Grasshopper”
“And do I get this guess from a Magic Eightball? Or from the wind?”
“No, Grasshopper, it’s an educated guess. No fingers in the wind. You start with the facts—the things that are real. To that you add assumptions about the future—how long you will live, what your investments will earn, how much your salary will be—such things as that.”
“So these assumptions, they are my predictions for the future?”
“No! No predictions! We are Shaolin priests, not charlatan fortune tellers!”
“Thank you for correcting me, Master. I am humbled by your wisdom. And where do these assumptions come from?”
“You must glean them from the world as you see it. You can take them from history. Or from indicators if you like. Or from reputable experts. Whatever source is rational and readily at hand.”
“Can I take them from different sources in different years?”
“Bad idea, Grasshopper. That is a prescription for fooling yourself. And a Shaolin priest, above all else, never fools himself. Try to avoid switching sources. Be consistent in the source for each of your assumptions”
“So this annual prediction . . . no, projection . . . it is my educated guess as to the most probable outcome for the future?”
“Close, Grasshopper. Not the most probable. But rather, the expected outcome. The probable center of all possible outcomes.”
“I think I understand, Master. But I must ask one more question if I may.”
“Knock yourself out, Grasshopper.”
“You said I could find reasonable assumptions from history if I choose, such as average returns on stocks or bonds. But Master Kan has taught me that history is no predictor of the future. So how is that a reasonable basis for making a projection? Or projecting an expected outcome?”
“That’s a tough one. We Shaolin masters think long term. And we believe that certain historical long-term tendencies are likely to reassert themselves in the long-term future.”
“That still sounds like double-talk to me. No disrespect intended, Master.”
“Shaolin masters do not engage in double-talk, Grasshopper. Now go out and preach the ways of peace. And beat up some bad guys with your stick.”
Tuesday, January 27, 2009
Adjusting for Inflation
In two recent posts, I discussed the necessity of taking inflation into account, and different ways to adopt a reasonable assumption about what inflation will be. (Not a prediction; just an assumption.) I guess it’s time to say something about how you go about doing that.
The easiest way to take inflation into account is to do it implicitly, rather than explicitly. Huh?
What I mean is best illustrated with an example. Let’s re-call Ernie. A couple of posts ago, we figured that Ernie needed to save for a target of $948,750. To arrive at that goal Ernie assumed his long-term rate of return would be 6%. But not really. He was hiding something (the scamp!). What he really assumed was that his nominal long-term rate of return would be 9% and that inflation would be 3%. His real (i.e., inflation-adjusted) rate of return was assumed to be the difference. Is 9% a reasonable assumption for a nominal earnings rate? For the time being, grant me that it is. So Ernie did in fact assume some inflation, but it was implicit, hidden in his 6% real rate of return.
In addition to making his arithmetic easier, using a real rate of return has another advantage. It keeps your numbers real (i.e., inflation-adjusted), so you can relate to them. If all goes as planned and projected, at retirement Ernie will have roughly $948,750 of purchasing power. He’ll actually have more than twice that in nominal dollars, but they’ll only be worth $948,750 in today’s dollars. The bigger nominal number has no sensible meaning; but you can certainly relate to the smaller real number because you have a feel for how far money goes today. (Actually neither figure carries any sensible meaning; what does have meaning is the $37,950 of annual spending that it will buy you. But that’s a whole other subject.)
In the example we constructed there’s another hidden implicit assumption. A few posts ago, we turned Ernie’s savings target into an annual savings goal of $11,426 (some of which is provided by his employer). Wait, you say, if he only saves $11,426 each year he won’t have enough at retirement after taking inflation into account. Good catch! But there’s this other hidden implicit assumption: That Ernie’s salary will increase with inflation. If it does, then when Ernie goes through this exercise next year, if all projections were to come to pass, his annual savings goal would increase by inflation, but it would remain the same percentage of his salary (11.426%). Ernie will have achieved his primary objective of having Future Ernie spending just as lavishly as Present Ernie, no more, no less. (This is the exact point made by an astute commenter to Wednesday’s post, some person named Anonymous.)
Is it reasonable to assume that your salary will increase with inflation? Ernie thinks it’s reasonable for him. What about you?
The easiest way to take inflation into account is to do it implicitly, rather than explicitly. Huh?
What I mean is best illustrated with an example. Let’s re-call Ernie. A couple of posts ago, we figured that Ernie needed to save for a target of $948,750. To arrive at that goal Ernie assumed his long-term rate of return would be 6%. But not really. He was hiding something (the scamp!). What he really assumed was that his nominal long-term rate of return would be 9% and that inflation would be 3%. His real (i.e., inflation-adjusted) rate of return was assumed to be the difference. Is 9% a reasonable assumption for a nominal earnings rate? For the time being, grant me that it is. So Ernie did in fact assume some inflation, but it was implicit, hidden in his 6% real rate of return.
In addition to making his arithmetic easier, using a real rate of return has another advantage. It keeps your numbers real (i.e., inflation-adjusted), so you can relate to them. If all goes as planned and projected, at retirement Ernie will have roughly $948,750 of purchasing power. He’ll actually have more than twice that in nominal dollars, but they’ll only be worth $948,750 in today’s dollars. The bigger nominal number has no sensible meaning; but you can certainly relate to the smaller real number because you have a feel for how far money goes today. (Actually neither figure carries any sensible meaning; what does have meaning is the $37,950 of annual spending that it will buy you. But that’s a whole other subject.)
In the example we constructed there’s another hidden implicit assumption. A few posts ago, we turned Ernie’s savings target into an annual savings goal of $11,426 (some of which is provided by his employer). Wait, you say, if he only saves $11,426 each year he won’t have enough at retirement after taking inflation into account. Good catch! But there’s this other hidden implicit assumption: That Ernie’s salary will increase with inflation. If it does, then when Ernie goes through this exercise next year, if all projections were to come to pass, his annual savings goal would increase by inflation, but it would remain the same percentage of his salary (11.426%). Ernie will have achieved his primary objective of having Future Ernie spending just as lavishly as Present Ernie, no more, no less. (This is the exact point made by an astute commenter to Wednesday’s post, some person named Anonymous.)
Is it reasonable to assume that your salary will increase with inflation? Ernie thinks it’s reasonable for him. What about you?
Monday, January 26, 2009
Projecting Inflation
Okay. So you’re planning your financial future and you know you’ve got to anticipate inflation. You know this because you’re observant and wise. Also because you read yesterday’s post. How much inflation will we see? Fagettaboutit. Nobody knows. You can’t predict it, you can only project it.
But that’s okay. You don’t have to be right in your projection; just be reasonable. Being the wise person that you are, your process includes a mechanism for annually updating your planning and projections based on reality—what really happened, not what you projected would happen. So next year, you’ll adjust for your inevitable failure to accurately predict the future, and effectively spread your error over the rest of your life. No, wait. Not “error;” that’s pejorative. Let’s call it “deviation.” No, that’s pejorative in a different way. Call it “dispersion.”
So what’s a reasonable assumption when it comes to future inflation? Here are a few options, any one of which is reasonable. Of these I prefer the first, since it presents a long-term average, and you’re planning for the long term.
• You can use inflation’s historical average. Between 1926 and 2008, inflation as measured by annual changes in the Consumer Price Index has averaged 3.01%.
• You can use the most recent rate of inflation. Between December 31, 2007 and December 31, 2008, the CPI has increased 0.09% (very tiny).
• You can glean the collective inflation predictions of many investors from the price of certain government bonds (called “Treasury Inflation-Protected Securities," or TIPS), which are designed to protect their owners from inflation. The rate of interest TIPS pay is generally lower than the interest rate payable on other government bonds with a similar maturity, and the difference represents, in a way, the bond purchaser’s prediction of inflation (as measured by the CPI) during that bond’s term. In fact, since interest rates on TIPS and other government bonds are set by an auction process, the difference in interest rate yields represents the collective inflation predictions of all government bond investors. As I write this, the most recently published spread between the yields on 20-year government bonds and TIPs is only 0.86%—not much. You can find the most recent interest rate yields for U.S. government bonds here (http://www.treasury.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml)
• Some financial institutions publish their predictions on their websites.
I don’t cotton to no predictions myself, and prefer instead to use a 3% inflation based on historical averages. It’s reasonable, and that’s all that counts. I’d be interested to hear your preferred approach to projecting inflation.
In any case, once you’ve settled on an inflation assumption to use in your projections, what do you do with it? That’s a subject for another post.
But that’s okay. You don’t have to be right in your projection; just be reasonable. Being the wise person that you are, your process includes a mechanism for annually updating your planning and projections based on reality—what really happened, not what you projected would happen. So next year, you’ll adjust for your inevitable failure to accurately predict the future, and effectively spread your error over the rest of your life. No, wait. Not “error;” that’s pejorative. Let’s call it “deviation.” No, that’s pejorative in a different way. Call it “dispersion.”
So what’s a reasonable assumption when it comes to future inflation? Here are a few options, any one of which is reasonable. Of these I prefer the first, since it presents a long-term average, and you’re planning for the long term.
• You can use inflation’s historical average. Between 1926 and 2008, inflation as measured by annual changes in the Consumer Price Index has averaged 3.01%.
• You can use the most recent rate of inflation. Between December 31, 2007 and December 31, 2008, the CPI has increased 0.09% (very tiny).
• You can glean the collective inflation predictions of many investors from the price of certain government bonds (called “Treasury Inflation-Protected Securities," or TIPS), which are designed to protect their owners from inflation. The rate of interest TIPS pay is generally lower than the interest rate payable on other government bonds with a similar maturity, and the difference represents, in a way, the bond purchaser’s prediction of inflation (as measured by the CPI) during that bond’s term. In fact, since interest rates on TIPS and other government bonds are set by an auction process, the difference in interest rate yields represents the collective inflation predictions of all government bond investors. As I write this, the most recently published spread between the yields on 20-year government bonds and TIPs is only 0.86%—not much. You can find the most recent interest rate yields for U.S. government bonds here (http://www.treasury.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml)
• Some financial institutions publish their predictions on their websites.
I don’t cotton to no predictions myself, and prefer instead to use a 3% inflation based on historical averages. It’s reasonable, and that’s all that counts. I’d be interested to hear your preferred approach to projecting inflation.
In any case, once you’ve settled on an inflation assumption to use in your projections, what do you do with it? That’s a subject for another post.
Sunday, January 25, 2009
Inflation: The Phantom Menace
In the past I would occasionally review a Will somebody wrote in the 1950’s or 1960’s. It might include something like a stipend for a favorite nephew of $100 per month for life. A hundred dollars a month!? That’s not even carfare! This little story is not meant to illustrate Aunt Gotbucks’s cheapness; $100 per month was a pretty decent gift when she wrote the Will in 1955. Rather the story illustrates the long-term ravages of inflation.
Whether you’re in your working years or your retirement years, your retirement planning is inevitably long-term planning, and that means you have to take inflation into account. A number of commenters (all named Anonymous) have astutely pointed this out.
What is inflation, anyway? Like pornography, we all know it when we see it, but it’s notoriously difficult to define and measure. Generally, inflation is the rise in price for the same amount of stuff. One thing that makes it difficult to measure is that it’s different for everybody, depending on the sort of stuff you buy. Do you need education, rent, a new TV or health care? They have inflated at different rates. And stuff changes. How do you compare the cost of a slide rule to the cost of an HP12C calculator? A broccoli to a Big Mac? And it’s different if you live on a farm or in the city, the Northeast or the Midwest.
Nonetheless, the U.S. Department of Labor maintains an index which attempts to measure inflation (actually, multiple indexes). You can find them here (http://data.bls.gov/cpi/). Of course no index measures your personal rate of inflation, but it measures something.
Inflation is silent and it's sneaky. It’s out there, eroding the value of your assets. It’s happening. But the guy on the nightly news isn’t screaming about today’s increase in the CPI, the way he’s in your face about today’s drop in the Dow.
It’s slow, building over time. Changes in stock values can be large and swift (these days sickeningly so). Inflation is slower. 2% one year; 4% another. But its cumulative impact over the course of your life will be large.
And it’s inevitable. There have only been 12 years during the 95-year period between 1913 and 2008 when the cost of living declined—only two since the beginning of World War II—and the most recent year that occurred was over 50 years ago, in 1955. (There were a few months in 2008 when the CPI dropped, but it increased slightly over the calendar year.)
I know what you’re thinking. Everybody is now worrying about deflation, not inflation. Yes they are. And the puppet-masters at the Fed and elsewhere in Washington will be doing everything in their considerable power to turn deflation back into inflation. That $2 trillion we’re currently adding to the national intergenerational debt will certainly support the effort. So from a planning perspective, you’d better count on inflation.
Individually, we can’t do anything to affect inflation. But as we plan our financial futures, we certainly should take it into account. I assure you I have done so in the examples I’ve spun in this column so far, and I will continue to do so in the future.
So how do you take inflation into account? That’s a subject for a couple of future posts. Right now I’ve got to go cash my monthly $100 check and buy myself a nice new tie.
Whether you’re in your working years or your retirement years, your retirement planning is inevitably long-term planning, and that means you have to take inflation into account. A number of commenters (all named Anonymous) have astutely pointed this out.
What is inflation, anyway? Like pornography, we all know it when we see it, but it’s notoriously difficult to define and measure. Generally, inflation is the rise in price for the same amount of stuff. One thing that makes it difficult to measure is that it’s different for everybody, depending on the sort of stuff you buy. Do you need education, rent, a new TV or health care? They have inflated at different rates. And stuff changes. How do you compare the cost of a slide rule to the cost of an HP12C calculator? A broccoli to a Big Mac? And it’s different if you live on a farm or in the city, the Northeast or the Midwest.
Nonetheless, the U.S. Department of Labor maintains an index which attempts to measure inflation (actually, multiple indexes). You can find them here (http://data.bls.gov/cpi/). Of course no index measures your personal rate of inflation, but it measures something.
Inflation is silent and it's sneaky. It’s out there, eroding the value of your assets. It’s happening. But the guy on the nightly news isn’t screaming about today’s increase in the CPI, the way he’s in your face about today’s drop in the Dow.
It’s slow, building over time. Changes in stock values can be large and swift (these days sickeningly so). Inflation is slower. 2% one year; 4% another. But its cumulative impact over the course of your life will be large.
And it’s inevitable. There have only been 12 years during the 95-year period between 1913 and 2008 when the cost of living declined—only two since the beginning of World War II—and the most recent year that occurred was over 50 years ago, in 1955. (There were a few months in 2008 when the CPI dropped, but it increased slightly over the calendar year.)
I know what you’re thinking. Everybody is now worrying about deflation, not inflation. Yes they are. And the puppet-masters at the Fed and elsewhere in Washington will be doing everything in their considerable power to turn deflation back into inflation. That $2 trillion we’re currently adding to the national intergenerational debt will certainly support the effort. So from a planning perspective, you’d better count on inflation.
Individually, we can’t do anything to affect inflation. But as we plan our financial futures, we certainly should take it into account. I assure you I have done so in the examples I’ve spun in this column so far, and I will continue to do so in the future.
So how do you take inflation into account? That’s a subject for a couple of future posts. Right now I’ve got to go cash my monthly $100 check and buy myself a nice new tie.
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