Monday, April 22, 2013

Inflation and the Cost of Living

The news media has been reporting some of the discussions between the two major political parties in the “reduce spending/raise taxes” debates –especially as they relate to “entitlement” reforms such as Social Security. One of the items being mentioned by the presidential administration is a change in the method of calculating cost of living adjustment (COLA) for Social Security benefits. The change basically involves changing how the Consumer Price Index (CPI) that drives the benefit increase is calculated.

Calculation of the CPI is complex and different people will be affected by it differently depending on the actual “basket of goods” they purchase. We are not going to have an in-depth discussion on the actual calculations and associated nuances here. If your actual purchases are food, energy, healthcare, and education related, your cost of living is greater than the approximately 2% the government is calculating now. The new idea is to use a “chained” CPI for calculating benefit increases. Chained CPI basically assumes that consumers will actually change their buying habits rather than just seeking cheaper brands. For example, if the price of beef goes up, consumers will start buying more chicken and not just substituting hamburger for steak. Hence the actual cost of living for the consumer should be based on the increase in chicken prices instead of beef.

So why are we having this discussion? It’s not just Social Security benefits that will be affected. How many other things are impacted by various COLA adjustments? How about the indexing that occurs throughout the IRS tax code? The lower the increase in those amounts, the greater the number of people who will be impacted by higher taxes (remember “only the very rich who don’t pay their fair share will see tax increases”?). But investors in particular should be ware. If an investor  believes inflation is only 2% when inflation is actually greater than 5% (and makes investment decisions accordingly in a 1.9% 10 year Treasury or 2.99% 30 year Treasury bond environment), then erosion of buying power is almost guaranteed. For most people, retirement is not difficult in the first 5-10 years. The problems occur in the later years when delaying retirement or earning additional income is not an option. Should you have any questions, please contact us at Paragon Financial Advisors; we can assist you in your retirement planning.

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