Your Retirement: The Double-edged Sword of Inflation

No one among us dislike lower prices for basic goods. If gas is inexpensive, our sentiment on the economy improves in tandem. If food prices fall, our personal budgets rejoice with the addition of some financial breathing room. Inflation has this effect like no other measure available in the economy.

And although the measure is of a basket of items (goods and services, ironically with food and fuel removed because of their volatile nature), it is a lagging indicator and open to refinements and adjustments. Yet it is still the number we associate with spending. How far each dollar will go is especially important in tougher economic times (and they don't get much tougher).

The inflation rate over the last nine years picked a year ago last month at 5.60% due in large part to the cost of oil - not the commodity itself but the effect it was having on the "goods" in the basket of measurable items. But since then, as oil prices fell, so has inflation. Last month it had turned negative at 2.10% (Here are the rates since January 2009 by month: 0.03%, 0.24%, -0.38%, -0.74%, -1.28%, -1.43%, -2.10%).

The bad news for seniors (and any other contract pay raise linked to COLA or cost of living adjustments), their benefits (or wages) will not increase in any noticeable fashion. Some seniors, if they pay for Medicare with a deduction from their Social Security, due to the increase in premiums, this lack of inflation will be easily mistaken for a cut in benefits.

Now, for some reason, which we will speculate on a little further on, the IRS is attempting to index your 401(k) deduction to this rate. If they are allowed to do this, and Congress can intervene before it takes place in 2010 tax year, your maximum contribution you are eligible to make will fall $500 to $16,000.

For most, this is a mote point. Far too many people are unable to make the maximum contribution in a time when employers have slowed, if not ceased matching employee contributions. But for those who can, this is a backdoor tax that could be the first step in drawing additional revenue for the government, at a time when it is needed most.

Exactly how much potential revenue is not known. There is still some legal wrangling to even see whether this can be done - it never has before - but I would be willing to wager that Congress will not act.

Folks who max out their 401(k) on salaries of $60,000 or less will need to have the rules rewritten in their workplace to allow for a contribution of that size to be made. Contributing 33% of you pre-tax income to your 401(k) would leave with a small paycheck (if you contributed just 5%, you would take home about $220 more than someone who made a maxed out contribution - which also includes some room for the employer to make their match) but a huge retirement nest egg, particularly if you have an early start of the process.

This will, without a doubt, have the biggest effect on high wage earners. Even with 14 million workers idle due to layoffs or other economic situations, the US work force totals 154,504,000. If the IRS is permitted to enact this change in deductions and assuming that the top 10% of the wage earners, the folks most likely to make that sort of sacrifice and you use the lowest tax bracket in the group, the government would, in theory, net an additional $2 billion in revenue.

So for the vast majority of wage earners, setting aside and investing any available pre-tax cash into your 401(k) plan is worth doing. Even if your employer has suspended their match or significantly altered it from the year prior, continue to use this type of plan.

And while I have you, I need to re-emphasize the difference between savings and investing. When you put money away in a retirement account, be it a self directed contribution or an automatic withdrawal via payroll into a 401(k) plan, you are NOT saving money. You are investing. My belief is that this may have been part of the problem with these plans; folks thought that they were saving when in fact they were investing.

Investing comes with certain obligations such as knowledge of risk and your tolerance to it as well as a keen sense on how to use that information over a long period of time.

If I could get everyone to call this what it is, I think we could approach this whole retirement situation with a more clear goal and calculated approach.

The 401(k) Returns... Almost

Your 401(k) is still in trouble. As the stock market rallies (although some think that September and October, historically bad months for the stock market will correct this), as the economy recovers (although consensus agrees for the most part that the recovery is not so much a bounce as a leveling off) and as unemployment remains the lagging indicator (along with housing), the effort at funding your future through your 401(k) languishes. Why? The employer is seeing that incentive to invest, the 401(k) match as not worth reinstating to pre-2008 levels.

For those of you who may not be aware, the 401(k) replaced the pension decades ago as companies divested themselves as guardians of your future. Pensions were the repayment for loyalty, human capital and profits. The 401(k) on the other hand was directed by the employee. Business used the incentive of the company match, a dollar for dollar investment up to a certain percentage as a way to encourage loyalty, human capital and profits.

Then the economy turned sour. And in the process of cost cutting, many companies eliminated or greatly reduced their company match. The question is: will matching of employee contributions ever return?

The short answer is yes. The long answer is: they will no longer resemble the employer contributions we have all become used to receiving.

Businesses face two problems when they decide to cut their 401(k) match. Neither is very appetizing and may even cost the company more than they bargained for.

For most plans, reinstating their 401(k) will not happen until 2011. Because of what is known as a safe harbor rule, reinstating the company match needs to be in the books by November of the previous year. To take effect in 2010, companies will need to feel as though the economy is on stable footing. This is not yet clear and may not be clear by the fall.

If the economy recovers at a faster pace than anticipated and jobs begin to return before 2011, the competition to get and in many cases retain good employees by offering these incentives will be missed. This could be a costly mistake for businesses looking to get and keep quality workers.

If the economy merely levels off, these employers will have time to see if some new techniques, currently being offered by Starbucks, might be the way of the future. Starbucks is breaking the mold for 401(k) plans by changing the incentive to profit based contributions. In other words, the company does better and in return, you get something for your retirement besides what you invested.

Will it work? Will other businesses follow? Possibly yes to both. The current corporate thinking is leaning towards less incentives believing that their plans were too generous in the first place. If your company has struggled through these tough economic times, particularly if you are associated with the automotive industry, those incentives, many experts agree, will never return.

A great number of other industries are planning to ease back into the incentive by offering substantially less in matching contributions and promising to raise those levels once they are assured the economy has recovered.

Some may simply be waiting to see of the Starbucks model works.

Does this mean the end of the 401(k)? No. Instead, you will have to earn more, put away more and invest with slightly more risk than you would like to assume. This means keeping your money out of staid index funds and target-dated funds in favor of investments that could do better. For some, this will be re-entering a high-risk investment model that did not pay off previously, evidenced by the cutting many nest eggs by a third or more when the market soured.

The next year will prove to be among the most interesting of the recovery.

Which Recovery is Good for Your Retirement?

We are at or near or nowhere near a recovery. No one knows. But that doesn't stop the speculation and with good reason. Most investors try and position themselves near where they feel the seeds are planted - the green shoots if you will. But this recovery, which had devastating long-term effects not only on retirement plans but the investors who use them to secure the future, is different than previous returns to normalcy.

In the recent past, we have had three major blows to the economy. 1973 was a good example of an oil driven recession. Most Americans were caught completely by surprise. For many people, it was the first time they had ever felt globalization in their paychecks. And more than just the long lines at the pumps brought this realization to their front door steps.

The recession that began in the third quarter of 1973 was not initially inflation driven. In fact, it was the nominal interest rate of 10.2% and inflation rate of 7.4% (if they seem high compared to our current rates, they are), the collapse of investments, consumer withdrawal and the overall lack of spending that pushed the unemployment rate to almost 10%.

The recovery was spurred forward by a huge tax rebate engineered by Alan Greenspan. And while inflation seemed to come under control, albeit briefly, unemployment rose as some industries that are traditionally hurt during a recession - housing, manufacturing - took longer to recover. By 1980, the trouble with banks (deregulation led to riskier lending practices, higher federal deposit minimums) only added to the problem. By 1982, the prime interest rate was at 20%.

Banks failed, Savings & Loans collapsed and the corporate tax increase and the deficit spending by the government instituted by the Reagan administration all contributed to the length of the recession. But it was the contraction of available money (money supply) by the Federal Reserve that caused the downturn. And helped its recovery by 1984. By that point, inflation was down to 3.2% and two million Americans had returned to work.

The next recession hit the world as consumer confidence (which had soared, declined) and consumer spending (spurred on by unrealistic optimism) became global players. We had developed into a nation of consumers and the world was now our producer. When we stopped spending with the first Gulf War and the rise in oil prices, the rest of the world's economy (the exceptions were Japan and Germany) fell.

The recession that began in 2008 is well documented and still lingering. But the signs of recovery are beginning to poke through. The problem is, what and when will it end and when it does, what will the new post-recession economy look like?

The credit shocks that the economy has felt are still reverberating. Bondholders will be offered riskier high yield bonds to help alleviate this debt burden. Current bondholders will be asked to lengthen the maturities on the bonds they currently hold and job creation will be the last piece of the puzzle needed to see any meaningful recovery.

Business are still testing their limits, stretching what few resources they have in an effort to position themselves for their shareholders. This pressure will keep job regrowth to a minimum as businesses figure out what to do next. Just as many investors have removed risk from their portfolios, so have the businesses we invest in (whether it be directly through stock purchases or indirectly, through mutual funds).

This makes planning for a retirement in this environment doubly difficult. Those close to retirement will have little time to bring their portfolio losses back to pre- 2008 levels quick enough to make a significant difference (the economy needs retirement in order to create jobs for people entering the workforce).

Those looking at a retirement ten-years and beyond have lowered their risk significantly as well, opting for index funds and indexed ETFs or by lowering their investment contributions. Both of these will force retirement further into the future.

Although consumers won't see raises for many years to come, the slowdown is allowing many banks the opportunity to work through the bad loans still on the books. Businesses will begin capital spending but only barely in the next year.

The key to benefiting from this recovery involves more than increasing your savings (which is considered an economic inhibitor) and getting your financial house in order (refinancing during these low lending rate events and realigning spending). The key is still investment and a healthy dose of investment risk. Confidence in the fact that you may not lose your job, you will keep your house and possibly even build that emergency savings account for the first time leaves the average person with a risk gap that only stocks can fill.

If you do not maintain at least a 5% contribution level and keep it in actively managed funds, those looking to pick stocks in this sort of market, you will miss out on some unusually attractive opportunities at rebuilding what you may have lost.

In other words, 90% of Americans will feel the recovery long before any other part of the economy will. They just won't realize it.