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Jurg M. Lattmann

You've done your homework and prepared for the day you turn 65. With the help of compound interest, mutual funds, tax shelters and insurance products you've reached your goal.

Then you expect the hard-earned money you've put into solid investments to keep you basking comfortably in the light of those sunset years. But how long can you really live off the income of your retirement fund?

Your calculations should reflect three important themes -- inflation, taxes and longer life expectancies. And quite likely, you will have to consider asset protection as well in this litigious age.

The world is constantly changing. Your retirement plans will have to be able to adapt to new realities.

How much is enough?

It depends, of course, on your lifestyle and how much the things you aspire to have will cost. But let's take a modest amount of $50,000 a year, about double the per capita annual income in the United States, or an engineer's annual wages in Chicago. We assume the Federal Reserve will do its job the way it has in recent years and inflation remains at 3 percent, compared to 5 percent in the past 15 years. If our fictional portfolio returns 6.15 percent annually after taxes, our saver needs more than $700,000 to stretch his retirement money 20 years out. At this spending level and return, a fat $1 million can get him to his 97th year.

These figures apply if his last paycheck is in the mail, or if his retirement is not too far off. Otherwise he has to adjust for inflation again. The dollars he earns today won't buy him the same amount of goods in 15 years. Taking a 3 percent annual cost of living adjustment means he'll need $78,000 in 15 years to buy $50,000 worth of goods in today's dollars. With $500,000, he's likely to be bankrupt in his early 70's; with a million, he's good for another 17 years or so from the day he retires.

No, even a million won't be enough if he lives 20 years longer -- and he just might according to actuarial tables.

But isn't inflation beaten

Inflation has come down significantly and in Europe and Japan, deflation is touted as the new ogre. But it would certainly be premature to say inflation is down for the count. In developed countries, central banks are reflexively loosening their monetary grip at the specter of recession. There is no assurance that the current drive to increase liquidity won't lead to inflation, if not now then in later years. In developing countries, inflation is still an everyday household word. And as these countries grow, and at the rapid pace some of them have been keeping, demand for increasingly scarce raw materials could push global prices up.

While the recent relentless rise in food prices on commodity markets is largely due to weather conditions, rising standards of living in rapidly industrializing countries may also tip the balance of food supply and demand. For the past 20 years, this balance has been the product of having half of the world go at least a little hungry.

With China alone making up a quarter of humanity, its growing economic power and ability to finance all the grain imports the population needs could easily lead to excess demand in world grain markets. Higher inflation paced by food prices would result.

While the above scenario is relatively benign nasty surprises can and do occur. Another oil shock, for example, cannot be ruled out. Not its inflationary consequences.

Demand for oil is mounting. In the past 10 years, China increased its per capita consumption of oil 33% and India, 50%. Fortunately, oil supply has been relatively stable in the same period. But, recent reports suggest it may not always be so; oil stocks in OECD countries at the end of last year were at their lowest levels since at least 1980. According to the International Energy Agency, future oil price movements hang largely on the extent to which these stocks are rebuilt.

So planning for some moderate level of inflation is a prudent investment strategy. The dollars you save have to work for you just as hard when you're no longer working, maybe even harder. You'll have to be able to afford the things you'll need even if inflation multiples their cost.

The burden of living longer

Demographic trends have been a primary reason for the instability -- if not bankruptcy -- of government-sponsored pension schemes in the graying developed world. Individual investors are faced with the reality of the social safety net being pulled out from under them, or at least severely curtailed. But also, longer life spans mean that an investor's private portfolio will now be burdened with the task of having to provide income and security for much longer retirement periods. Alternatively, there is a chance that you -- or your spouse -- will live long enough to regret the investment mistakes you make with your pension funds.

Longer life spans call for a radical change in investment thinking. The conventional wisdom of financial planning is that once you retire, you ought to invest heavily in fixed-income assets. This has become an outdated concept. If you can now expect to live 20 years after retiring, your investment horizon at age 65 should still be looking towards the long haul. Modern medicine has made it worthwhile taking greater risks in order to increase returns on your investments. The alternative is to let inflation eat into them in the extra time you have. Inflation and demographics tends to equalize differences in investing strategies among pre-retirement investors and retired ones.

Suckers and Sharpies

An American economist, Arthur Okun, wrote in Inflation: The Problems It Creates and the Policies It Requires (New York University Press, 1970):

"Our financial system ought to serve both investors who want to earn maximum returns (and are willing to take substantial risks) and holders of reasonably safe assets who view their saving largely as deferred consumption. The latter are not accommodated during inflation; we thereby lose 'savers' surplus.' Inflation creates in this way an unhappy division of savers into 'sharpies' and 'suckers'... The former make sophisticated choices and often reap gains on inflation which do not seem to reflect any real contribution to economic growth. On the other hand, the unsophisticated saver, who is merely preparing for the proverbial rainy day becomes a sucker."

The seventies are seemingly a bygone era, but Mr. Okun's views remain relevant. In Okun's terminology, we all must strive to be that sophisticated saver, the Sharpie. Unless you are one of the lucky few, someone who won't have to worry about stretching his nest-egg benefits because he expects to or already owns the chicken coop, you need to invest in assets whose dollar income or dollar value can be expected to increase as the purchasing power of the dollar falls. Okun's views speak strongly for diversifying retirement assets and diversifying globally into non-dollar assets.

Specifically, Sharpies look at investment classes with higher returns (even at greater risk) or at investments denominated in an appreciating currency. Applying their strategies most likely will require that you cut back on your bond holdings. The most common retirement securities investors own, long-term government bonds (e.g. US Treasury or UK gilt- edged bonds), are the least inflation-proof in any country marked by a history of spiralling prices.

Other fixed-income securities -- triple-A corporate bonds, US annuities and endowment insurance policies -- which have traditionally been a good means of generating income are also hit by inflation. These would still provide a stream of income, but the buying power of that income -- when it's really needed -- will be reduced by inflation.

And the winner is...

Sharpies know from their lessons in financial history that the value of equities is more likely to appreciate over the long haul than that of fixed-income assets. And when taxes and inflation are calculated, stocks win hands down; investors lose money on Treasury bills and bonds.

It should be noted that stocks do not always beat inflation, even over long periods. Looking at the performance of the DJIA and the S&P 500 index in nominal terms and in constant 1995 dollars one will find that in the latter case, at the peaks around 1905, 1929, and 1964, stocks failed to recover against inflation within the next 20 years.

The period after those peaks were partially marked by stages of accelerating commodity price increases as well as high capital gains taxes, which wiped out increases in share prices.

Today, no one can predict how close to the peak stock markets are, nor how quickly they will recover if 1929 should repeat itself. But since inflation is currently at a moderate level and there is even talk of a "flat tax" which would eliminate capital gains taxes, stocks should have more room to grow in inflation- and tax-adjusted terms. But as we've discussed, the inflation scenario may still change. And so long as governments exist, taxes may still rise. So where do Sharpies, those flexible creatures, go?

They go global, of course. Diversifying internationally is another Sharpie hallmark. Since 1971, the Sharpie would most certainly have lived up to his reputation by diversifying into Swiss francs.

Copyright © 1996 by Jurg M. Lattmann
Reprinted with permission from Swiss Perspective: Strategies for Financial Security and Growth, April 1996.

Much more information on Swiss investing is available at Fortress Switzerland.

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