Inflation III. Personal inflation and retirement

When there is confusion in a system because of the excess of variables or its possible distortion, it’s advisable to try to look closer at the origins of the problem trying to find more clarity. From this comes the concept of personal inflation (PI).

Although all the parts of the economy are interrelated, they don’t have a prefect correlation. Thus, if you can estimate the inflation data that directly affects the retired person, precision will be enormously improved. Most likely, the price increase in university education isn’t a relevant factor for someone that isn’t going to start their studies, in the same way that the increase in housing prices isn’t to those who already own their own house and who intend to leave it to their inheritors.

A borderline case happens with health costs. For some, not being included in any type of public protection system is nearly their greatest worry, while for others it’s contemptible to find themselves under the state’s umbrella. Therefore, as a first step, it would be necessary to calculate those areas that can affect retirement and obtain specific historical data. As an example, you can imagine a couple that decides to retire to the Philippines. They rent, don’t have a car and have global health insurance. This couple will need to know the details of their last few years of rent in the Philippines and the evolution of health insurance in a global way. The rest of their expenses such as: food, telephone, Internet, electric, and water; affects them to a lesser extent and the average could be used to calculate them.

If they estimate a monthly payment of $500 on rent, $400 on insurance, and $800 on the rest of their expenses, and on average in the last few years rent has risen 8% annually, health insurance 7% and the country’s inflation is 2%, the following calculation can be made to obtain the personal inflation data:

PI=(500x8%+400x7%+800x2%)/(500+400+800)=4.9%

Calculating future monthly expenses isn’t complicated; in fact, it is where less uncertainty appears, despite the fact that uncertainty is always found in the future. What is not as trivial is estimating an average inflation for the retirement period. Perhaps rent in Manila has risen a lot in the last few years, but you encounter an unsustainable situation and it’s nothing more than the reflection of a real estate bubble that is on the brink of bursting. Or maybe the historical data on housing rentals in the last 30 years didn’t take the current situation into account. The solution to this problem doesn’t exist. Once again, you can make a reasonable approximation. If we call the average increase in rent in Manila in the last 30 years IA30, 3%, and IA5 the average increase in the last 5 years, 10%, as an example the following could be used:

i . If the couple is young, you can give more weight to the historical data, IA=(2xIA30+IA5)/3=5.3%.

ii . If the couple is old, then the recent data is overvalued, assuming that they have fewer years to live and there won’t be time for inflation to return to the average, IA=(IA30+1.5xIA5)/2.5=7.2%.

iii . The age of the couple is omitted and you simply use 1.5 times the official inflation of the rent history, IA=1.5xIA30=4.5% (you don’t use double, as in the general case seen previously, as in specific areas the distortion between the actual inflation and the official is less).

Logically, this is only an example. The weight of each type of inflation varies according to the particular scenario of the person making the calculations. In any case, prudence requires leaning towards a high inflation figure as a more restrictive situation. Therefore, it’s possible to calculate personal inflation without knowing more than the areas of expenditure that each one has and finding average inflations specific to each. Estimating these average inflations is an art, which can be used for future inflation. This applies as much to the historical data exclusively multiplied by a coefficient of security (for example 1.5), as to a combination of these historical figures with the more recent ones.

DYNAMIC MODEL

It’s healthy to make an estimation about future inflation through the methodology that is considered appropriate. However, to remain only with the initial calculation and never make a periodic follow-up during the retirement years would be a shame. This will be a constant in all the variables that affect retirement.

Recalculating the estimated future inflation each year or every other year upon retirement diminishes carrying forward previous errors and permits correcting the rhythm of expenses (or possible extraordinary income) to the new situation of corrected inflation. It is, therefore, a dynamic model, a process that doesn’t end during the whole of retirement.

Delaying gratification

After meeting many people who have successfully retired before 50, I found one thing in common. It's not they were amazing investors, or very lucky. Their shared characteristic was they all were able to delay enjoyment.

Some people might think this is not a virtue, and they could be right. However, to become a young retiree you have to have it. One of them said that when he was a kid, instead of going to the playground or talking between classes, he prefered to advance his homework.

Delaying enjoyment is something that can be learnt by children. It will give them more freedom because those individuals who find it difficult to delay gratification will often find it intolerable to have to put off their enjoyment.

Deferred gratification is also related to impulse control. In fact, there is a link between addictive personality and the inability to delay gratification.

Besides, it can be used to increase motivation. For instance, people on a diet can have a day off to eat junk food if they have been compromised the days before.

Last, psychologists say it's better to seize the day, which probably is right, but, again, to retire young you have to have the capacity of "seizing the day" by thinking of the future. That is a double twist!

SOCIMI

Las SOCIMI son la versión española de los REIT (Real Estate Investment Trust). Básicamente un grupo de inversores crea una sociedad para comprar y gestionar inmuebles. Normalmente uno puede comprar participaciones de una SOCIMI en el MAB (Mercado Alternativo Bursátil).

Para el ahorrador es una forma de tener exposición al mercado inmobiliario con poco dinero y sin preocupaciones. Tiene importantes beneficios fiscales que han hecho que incluso sea un tema que recientemente se tratara en la confección de los presupuestos del estado (enlace).

El problema de las SOCIMI es su falta de liquidez (muchas apenas realizan operaciones) y la ausencia de control por parte del inversor, ya que este se tiene que adherir a lo que decidan los gestores de la SOCIMI.

Aquí tienen un listado de SOCIMI:
https://www.bolsasymercados.es/mab/esp/SOCIMI/Listado.aspx

Miren lo que compra cada una. En unos casos serán inmuebles con malas perspectivas, en las afueras, centros comerciales venidos a menos, pero también tienen algunos con carteras más sólidas. Con las SOCIMI no todo vale.

Retirement planning

With this post, we are not dealing with the financial preparation to retire, but with the mental changes to ensure a smooth transition to the new phase of our lifes.

The time to start thinking about retirement is BEFORE we actually do it. There are two key elements: being realistic and involving our partners in the planning.

Of course there will be problems such as loss of identity, anxiety and boredom. The best shield against these hurdles is a combination of long-term and short-term planning. Prepare a bucket list of things to do, be more social, schedule trips with friends, create a gourmet group, join your favorite political party, spend time practicing sports... Each one of us knows what is best for us, but remember don’t wait until we face the problems, visualize it first, when everything is still cool and calm.

The One More Year Syndrome

Some people are lucky enough to achieve financial independence, however instead of quitting their jobs, they continue working for just one more year to have an extra buffer. The next year financially they are even better off, and again, instead of quitting, they stay just one more year. The above behaviour creates a loop that cannot be broken and these people end up never quitting.

The trigger for the OMYS is very powerful: a combination of fear and greed. What if my numbers are wrong? What if the stock market collapses (that should be taken into account)? I am too old and won’t be able to get a job, if needed. If I have more money, I could travel on this luxurious cruise. I’m going to pay the property tax of the house for the next 10 years before retiring.

One of the problems is to determine how much is enough. From our professional experience, “enough” is much more than what people get on the first calculation. In any case, once you figure out how much you need a year to live the way you want (that means travelling, restaurants, etc..., if desired), and you find reliable passive income that matches your expenses without forgetting inflation, the problem is solved.

If you suffer from OMYS, just create an extra buffer to use the new money on tangible purposes, and quit once you reach them without thinking. We have to remind ourselves that we can get sick and not enjoy the rest of our lives anymore. Also, that the mental transition from working to leisure is a tough one (it lasts more than a year) but the sooner and younger we go through, the better.

Perfection is the enemy of good.

Inspirational stories of people who early retired

Some writers recommend NOT to retire early because it is very difficult to do it in the proper manner. To early retire is a very serious decision and whisful thinking needs to be avoid. However, here we have chosen some happy stories that are very motivational. We hope you like them:

- 10 Inspirational Stories of People Who Retired Before 40

- 6 True Tales of Early Retirement Success

Early retirement, we are awfully sorry but...

...what we have heard about the 4% rule doesn't work anymore. Another way of seeing the 4% rule is "you can retire when you save 25 times your annual expenses" (link). For instance, if you think you need 4000 USD (or euros or pounds...) a month, you need 1.2M USD.

However, according to our updated simulations, the number is not 25x but 55x. We know, much worse. For instance, in the previous case we would need 2.6M USD.

Early retirement is a fair dream, however we cannot wishful think and fool ourselves. The amount of money we need if we don't have a pension is much higher than what we have been told. Remember: inflation exists and in the long run it matters a great deal.

Long-term returns depend on initial P/E...

In our article, 3 legs, we exposed one of the main problems related to retirement calculations: returns on stocks depend on initial P/E. Right now, the P/E is high, so to get 7% a year could be a dream. How can we estimate the stock yield?

Crestmont Research has done an amazing job with its stock matrix (link here). How do we use it? We choose a period with similar P/E on the left, and, following the same row, check out the nominal annual returns after 20, 30 years without dividends. For instance, from 68 till 98, the yield is around 8% a year. We can appreciate that when the P/E ratio is high, the following years it is difficult to obtain high returns (red and pink colors). However, after a certain number of years, in most of the cases, we get 5% at least (6% probable). So, in our retirement calculators, we could choose 5% plus dividends (lower line of the chart) if we are going to be retired for a long time. Around 8% could make sense. It took 60 years to get that kind of return after 1929 (3% in 40 years), though.

Have you thought of retiring in the Philippines?

If you are not very wealthy, but still want to enjoy a high-quality life, one option is coming to the Philippines.

First of all, we need to understand that this group of islands is huge, therefore it is possible to find our favorite spot here. We all know Manila is a dangerous city, but there are many places where safety is not an issue. The most popular expat locations are Cebu, Clark, Subic, Baguio and Iloilo.

Second, the Philippines is a very affordable country, however you want to be close to a nice hospital with decent standards. That is the other side of the coin: cheap but not Western quality. Still there are options. You just need to look for then.

And third, tax wise, if you are an alien resident, you won't be taxed on the money you make abroad, so basically if you don't work or have a business in the Philippines, you don't have to worry about paying taxes here.

Early retirement. Withdrawal. A game

Premises:

1. We start with C (initial capital) and we want to retire. We want to calculate "w" or how much we can withdraw a month and have a safe future.

2. We are going to hedge the longevity risk by creating a perpetuum mobile, meaning, we are going to keep the principal intact taking inflation into account.

3. Our portfolio will consist of 5% cash, and the rest: 8/13 dividend shares and 5/13 gold.

4. w is going to come exclusively from the dividends. Why? Because we are going to suppose that the inflation will be hedged by the increase in the value of shares and gold.

Solution:

PORTFOLIO=5/100[CASH]+95/100x(8/13[SHARES]+5/13[GOLD])

w=1/12xDIVIDENDx95/100x(8/13xC)x0.7, being DIVIDEND the dividend yield. 0.7 comes from taking 30% taxes into account. The final equation can be rewritten as follows:

w=34103xDIVIDENDxM, being M the number of initial millions.

Practical point of view:

If we happen to have 2.2 million dollars for retirement and we buy shares of solid companies with an average dividend of 3.5%, we can spend 2625 USD a month and feel safe.

From another angle, we think we can live with 4000 USD a month and will receive a pension of 2500 USD a month, how much do we need to retire? w=4000-2500=1500 M=w/(34103x0.035)=1.26 millions.

Some of you might think:

1. Why gold? To hedge the risk of the stock market.

2. Isn't it too much money for such a tiny yield? Inflation is a very powerful enemy, and to overcome it we cannot overspend.

Against the tide / A contracorriente

Today, we want to give you a present. 2016 is our 10th anniversary and we would like to celebrate it together. 10 years, almost 1000 posts talking about finance, politics, philosophy... is not a bad trackrecord. Last year, I wrote Against the tide, about early retirement and personal finances in general. The idea was to analyze all the variables that affect the preparation for retirement. There is a lot of statistical work behind but the book just shows the conclusions to make it very practical. So, if someone wants to receive a free copy, just send us an e-mail (or use the Contact form on the right) with your e-mail and the language you prefer, English or Spanish. We hope you like it. This is just the beginning of the many surprises that lie ahead...

Hoy queremos hacerles un regalo. 2016 es nuestro décimo aniversario y nos gustaría celebrarlo juntos. 10 años, más de 1000 artículos sobre economía, política, filosofía... no está nada mal. El año pasado escribí A contracorriente, un libro acerca de la preparación de la jubilación y las finanzas personales en general. La idea era analizar todas las variables que pueden afectar el retiro como la inflación, la esperanza de vida, la rentabilidad de la cartera (hablamos de cómo crear carteras con menor volatilidad, más estables) y demás. Hay mucho trabajo estadístico detrás que, en aras de la claridad, no aparece en el libro donde solo se muestran los resultados para hacerlo lo más práctico posible. Así que, si alguien quiere recibir una copia gratis, solo mándenos un correo electrónico (o use el enlace de Contacto de la derecha) con su correo y si lo prefiere en inglés o español. Esperemos que les guste. Esto es solo el principio de las muchas sorpresas que les tenemos preparadas para este año.

What is longevity risk? ALDA

We plan our retirement. We generously estimate our life expectancy (it might sound rough, but in most cases it's necessary). We own some wealth and calculate that, taking inflation into account, we can use this wealth to live until we die. But what if... we live many more years than our life expectancy?

In general, we don't like insurances because they have negative mathematical expectations for the buyer (otherwise insurance companies don't make money). However, there are things or events that we, as individuals, cannot risk to lose or suffer (like a house because of a fire). And "overliving" can be one of them if we are short of money.

We all know what an annuity is. It's kind of an insurance. There is one which makes sense, though. It's called ALDA or Advanced Life Deferred Annuity. If applied correctly, it can be very beneficial. The idea is to pay a lump sum today and leave it in the insurance company producing some yield until we get close to our life expectancy, when we will start receiving our monthly payments usually guaranteed.

Why waiting until 85 years old to get some returns from our investment? Because the cost of an ALDA is cheap and it perfectly hedges the problem we had at the beginning: the longevity risk or the possibility of running out of money because we are living more years than calculated.

Inflation, food prices

Official stats tells us that we have almost no inflation, that, in fact, we are fighting against deflation. Governments tell us that we don't have to worry about the increase in "money printing". At certain point, they say, it will be adequately removed from the monetary system.

We don´t believe it. Inflation is increasing in a much faster way than what politicians say. Probably, the biggest US export is... inflation. It´s being extended everywhere (we will see Asian Real Estate soaring, for sure). Governments cannot control debt anymore and they will try to create inflation (steal from our pockets) to pay their debt.

Just as an example, let's show you this self-explanatory Commodity Food Price Index chart from IMF data:

In 10 years, we have changed from 80 to 170, not bad. And there is even more. In the middle of the crisis, when the markets realized what governments were doing, it moved from 120 (2008) to 170 now. 

Acceptable returns

One of the main issues when planning your retirement is calculating a reasonable assumption for investment returns. However we cannot based our figures on past performance this time. Conditions have changed. Public pension funds are still using an annual yield of 8% which is absurd.

Long-term returns on the stock market mainly depend on the initial point. That is the reason we are always concerned about using multiple entries. The stock market on a normalized basis is priced pretty high nowadays. It was incredibly high some years ago, though. Therefore, we are expecting below-average yields.

A blended mix of bonds, stocks, real estate, and non-traditional tools might lead us to an average of 4% instead of the commonly assumed 8%.

Reverse mortgage

As we said in our previous article (here), we are going to continue with our retirement series from another point of view. Imagine that we developed a retirement plan, we retired, and, for whatever reason, we need more money. One option we may take is using a reverse mortgage (RM). The reverse mortgage allows us to take out a loan against the equity in our home, but we don't have to repay the loan during our lifetime as long as we are living in the home and have not sold it.

Usually, to be eligible we have to be 60+ years old. Once accepted we may receive a lump sum, or a monthly payment. It is a big decision that will impact the estate that we leave to our heirs, so careful planning is needed before applying. Besides reverse mortgages are expensive in general.

There are many  RM calculators. Just as an example, a man born July 1947 who owns a loan-free flat worth 250.000 USD can get a monthly payment of 333 USD, until he dies. His heirs will have to pay the loan if they want to receive the house once he died.

Check out this interesting article from Wall Street Journal.

Hyperinflation (too early)

We've been told some asserts that we think they are absolute truths. However, if we stop to think about them, they are not so clear. Example: deflation. For our politicians and media this is the worse curse for a country. We absolutely disagree. Deflation is one of the best mechanisms to reduce costs and optimize production. We know it will be tough, but at the end only the best ones will survive and the country will be clean for a brighter future.

However, we believe deflation will only happen during the next few years, because governments think the solution for the public and private debt problem will be to create inflation. With inflation, debts go down, the same as savings.

Let's remember some facts. First, you can read this small "wikiarticle": Hyperinflation in the Weimar Republic. Perhaps, now you understand why Germans are so afraid of "printing money". We are not talking about a small inflation like 5% or even 15% a year, but figures like the following: the wholesale index in January 1922 was 37 and in November 1923 726 Billion!

Second, all the savings from the middle class were gone in less than 2 years: bank savings, bonds..., all gone. Rich people improved, though. They owned land, gold, and stocks, which served as good hedges against hyperinflation. As you can see on the chart, the stock market behaved very poorly at the beginning of the crisis. In USD terms, it went down from 20 to 5. However, at the end, it was a very good investment. Probably, we will see a less extreme situation in years to come, and at certain point we will have to avoid bonds. The risk will be rewarded.

Retirement: another point of view

In our previous articles under Retirement, we have wrote about calculating "the number" or the amount of money we needed to be able to get an early retirement. As we have shown, this figuring was not easy. We required to estimate inflation (official and real), returns on our investments (real estate, stocks, and bonds), and longevity. Unfortunately, the results were difficult to obtain under certain safe ranges.

Now, we are going to start a new series of articles about working out the cash flow for retirement, not the initial number. We will need to find out:

• if real estate and stocks are good hedges for inflation,
• if it is easy to find a low-paid flexible job to increase our cash-flow,
• if it is interesting to use an inverse mortgage,
• if it is possible to lower our expenses once retired.

As always, we will try to be as realistic as we can, including taxes and different places to live.

Historical yields on real estate

It´s very difficult to get an accurate figure for the historical yields on real estate. So, first, let´s start with some previous papers:

- Jack Francis and others wrote a paper called “Empirical Risk-Return Analysis of Real Estate Investments in the U.S., 1972-1999” adapted in 2004. The advisers thought the yield averaged 8.6% annually during this period.
- Fidelity Research Institute began from 1963 to 2006, and found the absolute yield was 5.9% per year with abundant country variances.
- The Case-Shiller Home Price Index showed that the value of residential real estate grew by 9.31% in the U.S. from the period of 1998-2007.
- The University of British Columbia found a real return of around 2% in Canadian cities from 1985-2003.

Second, as a rule of thumb, nominal real-estate returns vary between 6-10%. As a big part of the real-estate bubble has already exploded, we could assume 8% as the average return for real estate. If we check out our estimate for real inflation (link here), we can get even with inflation.

So, to sum up, as we were saying in a previous article, if we invest the money for our retirement in good stocks, good bonds, and real estate, we could average 7% yield, which is the number we use in our simple retirement calculator. For inflation, we fill in a safe 8% (remember: real inflation, not official inflation), so, in fact, we don´t even beat inflation.

Play a little bit with the calculator, and you will see it´s really difficult to get a safe retirement with no extra income.

Returns on stocks based on intial P/E. Bonds

In our article, 3 legs, we exposed one of the main problems related to retirement calculations: returns on stocks depend on initial P/E (more about P/E, here). Right now, the P/E10 is high, so to get 7% a year could be a dream. How can we estimate the stocks yield?

Crestmont Research has done an amazing job with its stock matrix (link here). How do we use it? We choose a period with similar P/E on the left, and, following the same row, check out the nominal annual returns after 20, 30 years without dividends. For instance, from 68 till 98, the yield is around 8% a year. We can appreciate that when the P/E ratio is high, the following years it is difficult to obtain high returns (red and pink colors). However, after a certain number of years, in most of the cases, we get 5% at least (6% probable). So, in our retirement calculators (we have a Simple Retirement Calculator here), we could choose 5% plus dividends (lower line of the chart) for the box "Annual Yield on Balance" if  we are going to be retired for a long time. Around 8% could make sense. It took 60 years to get that kind of return after  1929 (3% in 40 years), though.

3 legs

We keep on talking about retirement. Today´s article is really important. It shows that there is not a Universal rule of thumb to calculate the amount of money needed to retire. This number is based on 3 legs: future inflation, future returns on investments, and number of years of living. If we happened to know these 3 figures, we wouldn´t have any problems finding out the wealth we´d need to retire (the same way 3 points determine a plane -I love 3-leg tables!).

As we have already exposed in a previous post (link), it is absolutely crucial the average P/E ratio the year of retirement. According to Crestmont Research, if the starting P/E (Crestmont adjusted) is less than 18.6, we could even comply with the 4% rule (withdrawing 4% of total money the first year of retirement, next years same amount plus inflation, during 30 years) if we invest all our money in a portfolio benchmarked by SP500. If it´s above 18.6, the success rate is only 76%. Right now the Schiller P/E ratio is more than 22 according to www.multpl.com. So...

From this point we want to make two reasonable modifications for an early retirement scheme: 1. instead of having everything in the stock market, let´s imagine that we have 1/3 stocks, 1/3 bonds, and 1/3 real estate, and 2. instead of calculating everything for 30 years, let´s do it for 50 years. We´ll do it in next articles.