Monday, June 11, 2007

Retiring in an Era of Declining Purchasing Power

I asked frequent contributor Harun I. to briefly address a topic which has long concerned him: the impact of our declining purchasing power on those with fixed incomes, and what hedging strategies they might use to lessen such losses.

In terms of what one share of the Dow Jones Industrial index buys in commodities, the "new highs" in the stock market are nowhere near new highs in actual purchasing power; our dollars buy less and less actual goods, despite the endless cheerleading we are constantly bombarded with about "low inflation" and "the strong dollar." Here is a chart which prices the Dow Jones Industrials Average in gold as well as dollars:

Please go to to view the charts.

One key concept here is the idea of hedging one's retirement income by buying and holding gold and/or non-dollar currencies, and prudently purchasing commodities or energy futures as hedges. In other words: by moving dollar assets to gold and other currencies, and purchasing futures, you may be able to retain far more purchasing power than if you left your nestegg in dollars or dollar-denominated bonds.

Here are Harun's comments, which reference an Excel spreadsheet that opens in a second window. (Mac and Linux users: if the link doesn't open, please download the file and open it in the appropriate software.)

"If you study the spreadsheet you will notice that, if you retired with 1 million dollars in 1986 you would have had pretty good purchasing power. Left un-hedged that purchasing power dropped off dramatically. I didn’t adjust for any interest received because at these numbers it wouldn’t have mattered much. Even if you had 1 million is bonds at 6% throwing off 60K/yr., you are still living on a fixed income. I didn’t adjust for taxes or commissions either.

Purchasing power improved from 1986-2002 because the dollar went to 120 or thereabouts. Even locking in the dollar value in 2002 would have not changed the picture much.

The Dollar hedge was a bust. Your situation wasn’t improved much. The Gold hedge worked much better in terms of purchasing gold and a basket of commodities but did not offset the increases in energy enough. This means that perhaps it would have been prudent to purchase energy futures/options as well as gold.

There are different ways to hedge with different instruments. This is just one example but I think it shows that, if you live long enough, due to flawed policies that require ever increasing expansion of credit and money, the very real risk of having your standard of living decline dramatically exists. (emphasis added)

It is time that we all stop looking at the futures markets with the casino mindset. There is a very valid and valuable economic function of these markets. Used prudently, they can protect us from declines in our standard of living due to rising prices. Who, after 20 years of retirement wants to have their ability to put fuel in their vehicle fall by 90%? Keep in mind that this is just a discussion on goods. The costs of medical services are spiraling, as we all well know.

Who can look at the spreadsheet and still believe that retirement is a time where we must become risk averse? Becoming a millionaire (yawn) is not that big of a deal when you really look at what it means. Every gadget we use dollars to buy today is dollars that lose the opportunity to grow to serve us in the future. And to think that the savings rate is negative; what are people thinking?"

For another perspective on the loss of purchasing power, here is a chart of the Consumer Price Index components, 1978 - 2004:

Please go to to view the charts.

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