Most Retirement Advice is Worse than Useless — Part II: Inflation

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.
—Henry Ford

If you read part 1 of this series, and thought to yourself, hm, they didn’t account for inflation, congratulations. You’re right. It’s a pretty glaring omission, I know. Everyone knows you have to account for inflation.

I’m sure you know how this story ends, but let’s go ahead and go through the motions, anyway. If you recall, our contribution rate was $1200 per year, from ages 22 to 65. We found out last time that using the more accurate CAGR instead of “average” return, we wound up with a little over $600,000 instead of the $1 million we were promised. Now let’s factor in inflation. As it turns out, the inflation-adjusted CAGR of the stock market from 1900 through 2011 works out to just 6.26%. Heading over to the retirement calculator and plugging in our new 6.26% “real” return, we wind up with only $241,751. Ouch. So much for our million-dollar retirement.

No surprises, here, right? But there’s a problem. You see, this figure is pretty much bullshit as well. To understand why, we need to look into what inflation really is, and how it’s measured.

What is Inflation, Exactly?

Strictly speaking, inflation is an increase in the total amount of money in circulation. Rising prices are just a side effect, reflecting the loss of purchasing power you get when there is more money chasing after the same amount of goods and services.

Most people don’t think much about abstractions like the total amount of money in circulation, though. They think about the price they pay for milk at the grocery store. That’s why when most people think of inflation, they are really thinking of something called the “cost of living.”

What is the Cost of Living, Then?

So what exactly is the “cost of living?” When most commentators from the government or the business community use the term, they are referring to something called the Consumer Price Index, or CPI. This figure is published periodically by the Bureau of Labor Statistics, and represents the government’s official position on what the rate of inflation is. It’s also what’s used to generate all the “inflation adjusted” returns you’ll see reported all over the Internet for every sort of asset (including the “real” return for the stock market I quoted above).

The thing is, the BLS itself states quite plainly that the CPI is not intended as a model for the cost of living, and you should take that to heart, because the odds that the CPI accurately represents your cost of living are slim to none.

What’s Wrong with the CPI?

If you wanted to model changes in the cost of living, chances are you’d put together a list of products and services used by a typical American family. You’d then add up prices from one year to the next, weighted for how much of each item people consume on average per year. Subtract the previous year’s result from this year’s, and you have your rate of inflation.

Makes sense, right? The trouble with this is assuming that there’s such a thing as the typical American family. If you don’t watch TV, for example, you don’t care if flat-screens are getting cheaper. If you’re a vegan, you don’t care if steaks are getting more expensive. This can mean that changes in your personal cost of living can vary wildly from what the CPI reports.

For some examples, let’s have a look at the weightings for 2011 in the CPI-U, which focuses on people who live in urban areas. “Food away from home” is weighted at nearly 6% of a family’s budget. I’m sure this is accurate on average, but what if you live a frugal lifestyle and rarely if ever eat out? Similarly, transportation is weighted at 17% of the average budget. What if you bike and walk everywhere, don’t own a car, and rarely take public transit?

Housing costs are especially troublesome. They are weighted at a whopping 41%, but price trends for these can swing hugely in either direction depending on which part of the country you live in. Housing prices in the DC area, where I live, for example, did not see anywhere near the decline that other parts of the country experienced during the subprime meltdown. Furthermore, you may well plan on moving to a much less expensive area when you retire. And naturally, if you have a paid-off home, your housing expenses are going to be very different than a renter’s.

In short, you should plan your retirement based on the choices you will make, and the lifestyle you want, not what the government estimates a “typical” household will do. Stay tuned to learn how to do precisely that.

Note 1: The real situation is even worse, for the $241,751 figure assumes you adjusted your contributions for inflation, which was not part of the original plan laid out in part I. The real result you’d receive if you didn’t adjust can’t be computed without knowing the particular years in question, but would be far lower.

Note 2: The original version of this article included a discussion of changes over the past few decades to the CPI calculation methodology due to the findings of the Boskin Commission. After receiving some feedback, I realized I had relied on some poor sources, and the discussion was thus overly simplistic and potentially misleading. The issue was ultimately beside the point, in any event, so I removed it.


  1. It makes me so mad when I see CPI figures and learn about how they calculate it.

    I also understand that they don’t take into account the cost of gasoline when they figure out his CPI stuff either? Is that right? Seems unfair when fuel costs are a significant portion of most people’s budgets.

    My hope is that my investment income will keep up with inflation as well. Do you think a dividend investing strategy is best able to do that? That seems to be the way my adviser is leaning.

    • Sean Owen

      Regarding fuel, this is a common misconception. The overall CPI figure includes the cost of energy. The “core” CPI, which gets a lot of attention among analysts, excludes food and energy – the reason typically given is their volatility. However, cost of living adjustments are pegged to the overall CPI, which does include energy.

      As for dividend investing, I’m a big fan. But of course it should be one part of a broader, diversified strategy. You should never put all of your assets into the stock market alone.

  2. Ah, I had forgot about volatility of fuel prices….also, I wonder how much subsidies and things like that would affect the CPI calculation as well?

    Because is not our fuel cost artificially lowered somehow anyway? I wonder if that would have any affect on the CPI and cost of living adjustments.

    All I know is that those lousy TIPS investments look like a bum deal, especially when you look at some specific examples of various consumer items, the CPI just does not seem to keep up with most real world examples. But now I understand quite a bit more about why the “powers that be” keep the CPI understated. I knew about one of the reasons but not the other.

    Also I have a mix of bonds and precious metals in there as well but I see how well the dividend stocks do and it makes me want to convince him to go heavier on those! Of course I am not sure he would listen to me anyway, he could probably talk sense into me.

    At any rate I need to move fast and get earning again so that my current investments do not go to waste.

    And a question: can we request topics for you to cover on this blog Sean?

    • Sean Owen

      > but I see how well the dividend stocks do
      > and it makes me want to convince him to
      > go heavier on those!

      Be careful. Chasing performance is generally spectacularly bad idea. You’ll have better luck doing the opposite and going against the crowd. But working on earning more to invest is always a good idea.

      > can we request topics for you to cover on this blog Sean?


  3. Oskar

    As I understand it higher prices (or lower) for homes is not included as homes are in theory an asset. There are however two problems with this:
    1. you will allways have to live somewhere
    2. modern houses are built to last 30 to maximum 50 years which makes them a (long life) consumable. After that period of time you will have to make renovations equal to the cost of building the house or construct a new house.

    • Sean Owen

      Well to be fair, the CPI still includes a housing component, they just track what they call “equivalent rent,” i.e. what you’d pay to rent a house of the same size. Whether this is a fair representation of the costs of home ownership is debatable, of course, but it’s not quite right to say that housing is not included.

      Over those 30 to 50 years, the rent ought to add up to more than the replacement cost for the house. But it can lead to some pretty distorted results in areas like San Francisco where real estate costs have grown vastly faster than rents.

    • Great discussion here!
      I must step in and argue with Oskar, however: houses today are much better-built than they were in previous decades, and the standard has been increasing for at least 70 years. Interior cosmetics aside, the basic bones are much stronger due to the effects of drastic improvements in the building code.

      Because of this, I consider depreciation and repair to be much slower on a newer house than on an older one in equal cosmetic condition. This actually has a material effect on my retirement expense calculations, because I’ll surely move around and I may end up in an older house than the new-ish one I currently inhabit.

      Based on the horrible construction quality of the many 80-100-year-old houses I have worked on, and the fact that they still lasted 80-100 years, I would say houses built today are good for at least 200 years!

      • Sean Owen

        Especially in the hands of someone with skills like yours, MMM. 😉 And even if the house rots, the land it sits on does not. You can always rebuild.

  4. I like your perspective on planning your retirement (and the impact of inflation) on choices you will make. I was thinking about this again this morning after reading an article on rising gas prices that could rise to $5/gallon in the next year. Since I ride my bike everywhere, this has a tiny impact on me. To some others, it means hundreds of dollars per month… Although it’s also true that rising gas prices will raise the prices of almost everything you buy, so it will impact pretty much everyone to some extent.

    One thing I wanted to bring up is that inflation is not just based on the amount of money in circulation. It’s also based on long-term supply and demand. If people keep driving more, and oil continues to get more difficult to drill, then we will see inflation independent of the amount of money in circulation. This is true for all non-renewable resources as supply dwindles.

    • Sean Owen

      Yeah, rising oil prices will affect everyone, as the price of oil has a huge effect on food prices, for example. But it will affect you much less than other people if you don’t drive. So the weighting the CPI puts on energy isn’t going to be accurate for you.

      Similarly, the weighting they put on consumer goods is going to be way off for someone who chooses a frugal lifestyle.

      Regarding your second point, strictly speaking, inflation was originally defined precisely as an increase in the money supply – no more, no less. Many old-school economists still insist this is the proper definition. Rising prices are a common side effect of this, but they can also be caused by all the other factors you mention.

      Nowadays most people equate inflation with rising prices, so under that usage you’re right. I’m just a bit old school I guess. 🙂

  5. Great series! You really bring up some concepts that are typcially accepted as unquestioned truths. I’ve been thinking of the real impact that inflation plays both on the standard of living and how it influences our investment choices for a few months now. Yes, if your the “average” urban dweller who is 49 years old making 68k a year spending 48k a year then the numbers from the Consumer Price Index might mean something. I’m going to go out on a limb and say that those reading this blog or any money/investment related blog are not the “average” spender or will not remain so for long.
    We spend a great deal of time accounting for inflation in our investment activity, but I think an equal if not greater amount of time should be given to the consumption side of the equation and how changes in our spending behavior will also impact the required rate of return we think is needed.
    Good stuff, keep it up.

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