Deflation: A Little Economic Gem for Retirees

(MoneyWatch)  The government just released the April Consumer Price Index figures. And in that data was a little gift to retirees: a bit of deflation.

Over the last year, the CPI decreased by 0.7 percent. Basically, this means it's about one percent cheaper to live today than it was a year ago. While we don't want serious deflation, a small drop in prices is helpful in keeping the lid on inflation.

While many retirees get concerned about bear markets, the real threat to long term retirement security is inflation. Bear markets are dramatic and for obvious reasons create lots of worry. But they're generally not permanent destroyers of wealth. Why? Because markets generally recover and wealth is restored.

But inflation is a different story. It's a permanent destroyer of wealth, particularly for retirees. As the cost of living increases, and you have a fixed pool of savings, you're getting poorer each year. And prices generally don't come back down.

The last big inflationary cycle started in the 1960s and ended in the mid 1980s. When we run historical simulations for retirement income portfolios, this 20 year cycle is the one that creates the most problems. Basically, high inflation drove the need for larger income distributions each year and depleted the portfolios pretty quickly.

Consider this example:

• Assume you had $500,000 in 1962 and were living off $25,000 a year in distributions.
• Over the next 25 years, to keep up with inflation, your annual distributions would have had to have grown to about $91,000. That's 18 percent of your original retirement account value.
• At that level, it only takes about six years to eat up all your savings.

That's why it's so important to keep inflation in check. But with all of this stimulus money floating around, the odds of high inflation down the road are pretty significant - although not a certainty. So for the time being, you can take some comfort in the current numbers.

Bottom line: While the volatility in the markets is scary, if you're retired, inflation is the bigger threat to your long term financial security. As long as it stays low, the odds are pretty good that you can get through this economic crisis.

If you're interested in learning more about how inflation could affect your retirement savings, you can read my article Don't Overlook Inflation.