Inflation is running at 8.3 percent a year. This is a retroactive rate. It tells us that prices in April were 8.3% higher than last April. On a forward-looking basis, things look much better. The monthly price increase in April was 0.3%, compared to 1.2% in May. At this rate, inflation over the next 12 months will only be 3.7%. Both nominal and inflation-linked bond markets jointly predict even less inflation, around 3%.
But predictions can be far off. Last April, the market forecast annual inflation below 1%. Moreover, according to the latest data, core inflation rose from 0.3% in March to 0.6% in April. Core inflation excludes food and energy price volatility. If inflation runs at 0.6% per month, we are talking about 7.4% inflation next year.
Can high inflation continue? It can. Bottlenecks will ease and grain and energy prices will fall as other countries compensate for reduced supplies from Russia and Ukraine. But the long-term financial situation of our nation is dire. And, like other countries in fiscal difficulty, our country makes money by making money, that is, by printing it (electronically). If Congress does not raise taxes or cut spending, high inflation could take root.
For retirees living on fixed incomes, inflation at, say, 7.4% means financial ruin. About 12 million retired public and local government employees live on pensions whose COLAs (cost of living adjustments) are generally limited to 2-3%. Their pensions have lost at least 5.5% in purchasing power over the past year. A decade of 8.3% inflation will halve their real retirement incomes. Yes, social security benefits are indexed to inflation. But most police officers, firefighters, teachers, etc. retired receive no benefits or greatly reduced benefits from the system.
Is inflation also hitting the 52 million other American retirees? Absolutely. Yes, their social security benefits are indexed to inflation. But the taxation of these benefits is not. There are two thresholds, set in dollars, above which 50% and then 85% of Social Security benefits are subject to federal and some state income tax. With enough inflation for enough years, sliding Social Security brackets will leave all recipients paying taxes on 85% of their benefits.
Besides its impact on real after-tax pensions and social security, inflation is an investment nightmare for all retirees. It is collapsing in the stock and bond markets, largely due to the enormous uncertainty about its future course. For those who flee to cash, treasury bills or their equivalents, inflation turns these “safe havens” into guaranteed losers.
Suppose you put $100,000 in a checking account in the past year because you feared the stock market was overvalued and the bond market was crushed by rising interest rates. Well, your flight to safety cost you $8,300 in buying power.
What about buying inflation-indexed bonds, called TIPS (Treasury Inflation Protected Securities). If you buy and hold TIPS, your real pre-tax return is guaranteed. But not your real after-tax return since inflation as well as the real component of the TIPS return is taxable.
I looked at the tax impact of inflation by holding TIPS. Of course, each case is different. But I considered a hypothetical 65-year-old woman, call her Maya, with $2 million invested in 30-year-old TIPS with zero real return. If inflation stays at 7%, rather than 0% year after year during his retirement, his real lifetime expenses will fall by 14%. If Maya currently has $5 million, the success is 28%.
In short, inflation, at least for now, is wildly high. And it jeopardizes the finances of retirees, whether they are on fixed incomes, collecting social security or investing in what should protect them from inflation, namely TIPS.
There are three simple ways Congress can protect seniors from inflation. First, it can index the tax thresholds for social security benefits. Second, it may change the tax treatment of TIPS so that only the actual component of the return is taxed. Third, it can allow retirees to exchange nominal future income conditional on survival for inflation-indexed income conditional on survival at the same present (present) value.
So a 70-year-old retired Detroit police officer, Steve, might agree to pay the $50,000 retirement pension he will receive at age 80 to Uncle Sam for, say, $45,000 in indexed dollars. ‘inflation. This assumes that the current market value of the nominal benefit of $50,000 at age 80 is the same as the current market value of the actual payment of $45,000 at age 80. If Steve does not return the $50,000 at age 80, he will not receive the inflation-adjusted payment of $45,000.
This third policy would give seniors something the market does not offer: the ability to purchase inflation-indexed annuities. Retirees would buy nominal annuities and immediately enter into swap agreements that turn them into inflation-indexed annuities.
Only the government can protect us from the risk of an expected increase in taxation, because only the government sets our taxes. And only the government can protect us from the risk of inflation because only the government can control inflation. As for entering into futures contracts to exchange, on an annual basis, nominal dollars for real dollars, that is also something that Uncle Sam can easily do.
No one knows how long inflation will last, let alone its future rate. But there’s no reason Congress should allow inflation to financially terrorize America’s 64 million retirees.
Laurence Kotlikoff is an economist at Boston University, president of MaxiFi.com, and author of “Money Magic – An Economist’s Secrets to More Money, Less Risk, and a Better Life.”