I believe that inflation has the potential to be the greatest threat to many people's financial health. The following commentary addresses this issue. Kevin O'Keefe, CIMA®, AIF® is the Chief Investment Officer of First Affirmative Financial Network. He said everything I was going to say and said it better.

The Inflation Trap

R. Kevin O'Keefe, Chief Investment Officer

Inflation may be the critical financial planning issue of our time. One of the biggest risks retirees face is the erosion of their purchasing power during retirement. And yet, many pre-retirees underweight exposure to stocks, which increases their exposure to inflation risk. Why? Perhaps the subtleties of inflation are a reason.

An Insidious Enemy

Inflation is a sustained rise in the prices of goods and services. Everyone knows that gas, bread, and movie tickets cost a lot more than they did 25 years ago, or even 10 years ago. Inflation is stealthy and insidious. Even though it has averaged only 3% per year since 1926, prices of most goods and services are many times higher than they were just five decades ago.

Inflation can easily double a retiree's expenses. At 3% constant inflation, prices will double in 24 years. But if inflation accelerates for a few years somewhere along the way, the problem becomes much worse. A 6% inflation rate would cause prices to double in 12 years. In times of high inflation, many retirees tap their accounts in order to keep pace. This reduces their principal, which in turn reduces its earning potential. Soon, the portfolio is depleted.

What the CPI Misses

As if a 3% inflation rate isn't enough of a challenge, the impact of inflation often feels greater than the rate stated by the Consumer Price Index. The CPI doesn't factor in income taxes, nor does it include price increases attributable to "quality" improvements in goods (new safety features in cars, for example). Nor does the CPI include health insurance premiums, which have increased by more than 10% in each of the past four years. And it doesn't fully capture the effects of higher property taxes or increases in home prices.

Everyone who spends money feels the sting of inflation. But there are some things you can do to manage the pain. Think about the combination of your assets and your obligations as one big portfolio that needs to be actively managed in order to minimize the effects of inflation. This means being disciplined when it comes to spending and borrowing. It means having a diversified investment portfolio with an appropriate allocation to equities. While no strategy is guaranteed to protect against a loss, over many years the risk of inflation may outweigh the risk of the stock markets volatility. Historic market returns provide persuasive evidence of this.

Even for our retired clients, we usually recommend investing a substantial percentage of their portfolios in equities (stocks). You can gradually decrease your equity position as you reach the end of your life expectancy, but getting too conservative too early increases the likelihood that you will outlive their money.