Terry Gerton Certainly one of the financial topics that is a almost daily headline is the inflation numbers. We hear it from the Fed, we hear Congress thinking about affordability, we hear it in terms of the president’s approval numbers. But when we talk about inflation from your perspective, what does it actually mean instead of just its shorthand?

Art Stein Well, inflation, you know, the shorthand definition is it’s just the increase in the cost of goods and services in the United States. And that determines our cost of living, which is a slightly separate definition. But when inflation goes up, for most people, their cost of living goes up. If your wages, if your salary is increasing the same amount, or even more, then that may not bother you. But if it’s not, then you have a problem. And the problem for FERS retirees is that their annuity, their pension, their annuity does not fully compensate for inflation any time inflation is greater than 2%. And that over a long retirement could be devastating. And it forces many FERS retires not only to have to withdraw increasing amounts of money from their investments, primarily their TSB for most retirees, and that may not be sustainable for them.

Terry Gerton So let’s just put that in practical terms because I think a lot of times people feel, think about inflation and it’s a feeling. It’s a vibe. It’s things are feeling much more expensive. My money doesn’t go as far as it used to. But when you’re on an annuity as your primary source of income, and you said FERS is indexed at 2%, inflation has been running considerably above that. How does that play out in people’s lives? What sort of choices are they making?

Art Stein Well, the choices they have to make, and let me just say one thing, the inflation adjustment for FERS is not fixed at 2%. If inflation is more than 3%, the cost of living adjustment is going to be whatever the inflation rate is, minus 1%. And if it’s between 2 and 3, then it’s just fixed at two, as you said. Problem is we’re seeing inflation higher than 3%. I mean, this year, the inflation rate in April was 3.8% and it was 3.3% in February. So FERS retirees are getting that minus 1%. So what people end up doing is they have to make choices. You know, one choice is to take more money from their investments of all types, including bank accounts. And the other choice is just to consume less, to purchase less, to do fewer things, buy cheaper food. Hopefully it doesn’t get to the point where they have to buy less food, but they might have to get cheaper food. I mean, we’ve seen a huge increase in the price of beef for various reasons, and so people are eating less beef. We’ve seen a huge increase in gasoline prices, and presumably, you know, people are driving less, although in the United States. Driving is kind of pretty fixed in with people. So some people will drive less, but a lot of people just keep on driving.

Terry Gerton So if folks are drawing from that FERS retirement as their principal source of income, what should they be thinking about? Are there different allocation strategies that might mitigate the impacts of inflation on their available balances?

Art Stein Yeah, so with the TSP, you know, a common mistake that people make is long-term investments — you know, all in the G Fund, I mean, are a majority of the money in the fund, and even the L Funds make the same mistake — they’re very heavily invested in stocks in the beginning, but starting about 10 years before they mature, they become way too invested in bonds and they end up, the L Income Fund has about 67% of everyone’s investments in the G Fund and another 5 or 6 percent in the F Fund. And the problem with those funds is once you take into account taxes and inflation, they lose purchasing power. So it’s very misleading because, you know, if you have money, say, in the G Fund, every year you just see that amount increase a little bit, assuming you’re not putting money in or taking it out. And you think, great, it’s going up in value, but it’s not. The purchasing power is going down. The dollar value is going up. And those are two very different things. And so, you know, if people have a lot of money in those funds, they’re in for a rude shock in 10 or 20 years because all of a sudden they’re realizing, oh hey, I have to take out more and more money from the G and the F Fund to maintain my purchasing power.

Terry Gerton Art Stein is a certified financial planner with Arthur Stein Financial. Art, what’s a smarter way to do it then? Should people broaden the asset classes that they’re invested in?

Art Stein Okay, so, let me just also say there are two other mistakes that are very common that people need to watch out for. One is paying off their mortgage early. And the problem with that is that equity in your home and paying off your mortgage early increases the equity you have in your home. The equity in your home has a 0% rate of return. If the price of the home doesn’t change, the value of the equity does not change. Now, the price of the house goes up, equity is going to go up, but that’s a rate of return on the house. The equity is not really, you know, generating interest or dividends or capital gains, and it’s hard to use the equity in your home, you know, it’s locked in in various ways. Also, too much money in bank accounts is a mistake because, once again, bank accounts lose money to taxes and inflation. So what people need to do is to realize that historically only stocks have had a high enough rate of return in a well-managed, well-diversified portfolio, only stocks have had a high enough rate of returns to increase purchasing power after taking into account taxes and inflation. And that means a C and the S and the I fund. And I feel like the TSP recognizes this because the L funds, in the beginning, they’re very heavily invested in stocks. I mean, the new ones are about 99% stocks for the first 10 years, and they don’t even get down to 60% until about 10 years before they mature. But then they over-invest in bonds when they become the L income bond. So what I would say is one, make sure you continue to have a solid amount invested in stocks. If you are looking for a long retirement, don’t pay off the mortgage early, invest that money. Everybody can have an outside investment account. Make sure you have a good emergency fund. So maybe use it for that. And don’t end up with too much in bank accounts. Because all of those hurt you when we take into account inflation and taxes.

Terry Gerton Art, it almost seems like you’re turning conventional investment advice, and I’ll use my air quotes here, on its head, because people have been told that equities are risky, that you really should pay off your mortgage so that you don’t run a risk there. How should people think about this balance between risk and return when they are in their retirement years?

Art Stein Terry, the thing is, there are lots of investment risks. One of them is volatility. And bonds are much less volatile than stocks. No question about it. And bank accounts really don’t have any volatility. But other investment risks, the major one for long-term investors, is losing purchasing power because of taxes and inflation. So people should not say that bonds are safer. They should say that bonds are less volatile. They are safer in that one way, but they are riskier in terms of losing purchasing power to taxes and inflation. Stocks are more volatile, but they have historically had a much higher rate of return for people who are patient and willing to put up with major stock market declines, which, hey, they’re going to happen. You know, we haven’t had a stock crash in, you know, a while, and there’s one in our future. I mean, I know it’s going to happen, but we need to just be patient when that happens and hold on. And historically, that has worked out for people. Now, past performance is no guarantee of future performance. Certainly, there are reasons to think that stock returns in the future will not be as high as in the past. And I don’t know what’s going to happen, but I don’t disagree with the fact that there are reasons to think that. But I haven’t heard anybody say that stock returns are going to be lower than bond returns over long periods of time.