If an individual retires with a fixed pension benefit but without a cost of living (COLA) adjustment, over time, that pension will steadily lose its value to inflation. A plan must be put place to safeguard one's income against increasing costs. If left to the ravages of a 3% inflation rate, the pension income will be reduced by 50% over the following 25 years. There are two basic methods to guard against the loss of a pension's buying power.
One method is to discount the pension to its present value by an annual inflation estimate over a certain period of years. The present value is then inflated by the owner each year to offset reduced buying power. For instance, if a pension provides a payment of $12,000 a year then a discounted amount of approximately $7,000 is taken today. There are other factors to consider, such as a surplus of funds each year that can be invested, but we leave that calculation for another day.
The second method, one that I've chosen, is to set aside assets to fund the increased need for income. I simply built a spreadsheet assuming a 3% inflation rate and a 4.5% growth rate of funds. The table below summarizes the details and funds needed for each $10,000 of income. Anyone can use the $10,000 to calculate their own circumstance. It was found that by using these rates, assuming a 20 year lifespan within retirement , that 3.9 times the annual income was needed to fund the "inflation" account. Starting value was calculated to be $39,000 for the inflation fund.
|Years||Initial Income Inflated @ 3%||Inflation Increase||Fund Growth @ 4.5% less Inflation Increase|
The table points out the need to plan for inflation. If one disregards the certainty of inflation and does not plan accordingly, then their retirement standard of living will worsen each year. One of the great advantages of dividend investing is the built-in inflation fighting increases in payments. However, the recipient of a defined pension plan must plan differently.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.