In the past, insurance companies and pension funds have been keen to advertise the benefit of compounding arithmetic for savings. Over the last 30 or 40 years the rate has been lifted by inflation, but to understand the cost inflation brings you have to consider the whole savings cycle: not just the accumulation stage, but also annuity values in retirement. Furthermore, the historical experience of a typical working life should be compared with a theoretical sound-money alternative.
Let us assume a man works for 40 years, during which time he invests a fixed amount annually. This is invested mostly in bonds for a return that gives him a lump sum on retirement. The marketing folk stop at that point, but we shall go on. This lump sum is applied to an annuity to give a fixed income for the retiree’s life expectancy. Let us also assume that $1,000 is invested annually, and we shall use the average return on the 10-year US Treasury bond as our yardstick. The result is shown in the table below under the heading of Paper Money.
| Paper Money | Sound Money | |
|---|---|---|
| Annual payment at start of period $ | 1,000 | 1,000 |
| Bond yield | 7.18% | 2.50% |
| Inflation | 4.44% | -1% |
| Nominal value at end of Year 40 $ | 224,150 | 69,088 |
| Inflation adjusted value $ | 74,056 | 87,510 |
| Pension based on inflation-adjusted value $ | 6,458 | 4,750 |
| Inflation-adjusted value of last payment $ | 2,075 | 6,091 |
The nominal value of our pension-pot on retirement is an attractive $224,150, but during its accumulation price inflation has averaged 4.44%, so its inflation-adjusted value is only $74,056, implying that the difference ($150,094) is a hidden inflation tax, leaving our saver with only one-third of his savings in real terms.
Assuming the lump sum is then turned into an annuity at a continuing bond yield of 7.18% for a retirement of 25 years, this inflation-adjusted figure gives an annual income of $6,458, and if inflation continues to average the historic rate, the final payment will only be worth $2,075 in inflation-adjusted terms. Note how the purchasing power of the annuity falls over time while our retiree’s health and care expenses can be expected to increase when he can least afford them.
The reason for taking inflation out of the equation is so we can compare the inflationary past with a sound-money alternative. This calculation is dramatically different under the reasonable assumptions in the table’s last column: an average bond yield of 2.5% and price deflation of 1% annually. The deflation-adjusted outcome is significantly better than the paper-money example. Furthermore, the purchasing power of the annuity increases, in tune with the health and care needs of an aging retiree.
Our example is simplistic: bond yields have varied hugely since 1971, and we have ignored management fees and taxes. We have not considered bond yields that are exceptionally low today, so annuities taken out now will yield considerably less than our example shows.
The bottom line is the saver is impoverished by inflation to a greater extent than generally realised. The state has benefited from the transfer of wealth from its citizens’ savings, the result of monetary inflation, but at considerable future cost. The state is left with the welfare, health and care costs for an aging population unable to support itself and with an increasing life expectancy.
The cost of looking after growing numbers of impoverished retirees will become apparent in coming years, increasing government deficits more rapidly than expected. What we don’t know is when the markets will reflect the enormity of these future obligations.
This article was previously published at GoldMoney.com.
Cobblers.
I think that there are two problems with this example
The first is that real yield for the purposes of calculation investment return as seen under the paper standard (1.0718/1.044 = 2.66% ) is lower than that in the counter example of hard currency (1.025/0.99 = 3.53%) by 32% (3.53%/2.66%), so we are not comparing apples with apples.
The second is that in the example above the annuity rate used to calculate the pension payments at the end of 25 years is based off nominal yields. However, the vast majority of annuities bought in the UK are index-linked to RPI and as such would be protected from this particular problem resulting in a similar change in pension payments in both the paper and hard money standards. This inflation linking effectively means that in both government and private DB schemes, that the younger members will continually pay for the protected benefits of the older ones, whose pension values rise as they live longer, while the living standards of the younger generation are cut by persistent inflation.
The young man contributing to his pension scheme has to bear
1) the difficulty of generating real investment returns when starting with bond yields of 1% and inflation of 3-4%.
2) the reduction in the ceiling for which they can contribute income on a gross basis into their pension while those older than them have already fully contributed into their schemes.
3) the increase in taxation on pensions (dividends are now taxed whereas those from the older generation were able to compound their dividends gross).
The burden of government largess has fallen and will continue to fall upon the shoulders of those who are working. It is hard to feel too sorry for a generation that has benefited from deficit spending, and are sitting on all the financial assets whose prices remain artificially inflated through low interest rates, and as mentioned above, they’re protected through the tax system, not that they mind as they’re too busy crusining around the world. Given the retiring baby boomers are the biggest voting class though, would you really expect any different?
I am nearly through Ludwig Erhards ‘Prosperity through Competition’, his own account of the struggle he had to rid post war Germany of Cartels and Special Interest groups. Once this was achieved the economy grew 6 – 8% pa for 12 years and shut socialists and Liberals up (some thought for ever). Erhard refused to Inflate the currency and savings boomed allowing a sound basis for credit to be lent out rather than debt.
A brilliant read – this book should be made into a film – if only Mickey Rooney were younger he could have played Erhard.