How much can we afford to spend in retirement? The standard way of thinking about this is to assume that our current spending rises in line with inflation. This, however, is dangerous because some of us face higher inflation rates.
Take the last 20 years. During this time, clothing prices have almost halved and prices of technical gadgets, as estimated by the ONS, have fallen 80 per cent; this might be an under-estimate as smartphones and tablet computers couldn’t be bought at any price in 1998. On the other hand, though, prices of restaurant meals, beer in pubs and holidays have risen by 80 per cent; prices of recreational services such as theatre and football tickets and golf club green fees have doubled; electricity and gas prices have risen 170 per cent; and insurance costs have trebled.
Although overall CPI inflation has averaged 2 per cent per year in this time, the cost of some lifestyles has obviously increased much more. If you play a lot of golf, eat out a lot, take many holidays and have a big house to keep warm, inflation for you has been more than 2 per cent per year. And over the long term, even slightly higher inflation compounds nastily.
Herein lies the danger for many new and upcoming retirees (such as me). A lifestyle that’s affordable now might not be so in 20 or 30 years. Even if overall inflation stays low, the cost of some lifestyles will rise a lot.
There’s a reason for this. It lies in something pointed out over 50 years ago by the late William Baumol. Some industries, he said, can increase productivity faster than others. And where productivity grows slower, prices rise relative to those sectors where it grows faster. He called this the cost disease. For example, humans have become much better at making smartphones and flat=screen TVs in recent years, but no more productive in making restaurant meals. This means the cost of eating out has risen relative to the cost of phones and gadgets. And because falling smartphone prices drag down overall inflation, so restaurant meals’ prices have risen faster than CPI inflation.
Generally speaking, productivity improvements are more likely in goods-producing industries than in services. Prices of services, therefore, tend to rise faster than goods prices over time. In the past 20 years, goods prices have risen only 18 per cent (0.8 per cent per year) while services’ prices have almost doubled.
If you spend more than the average person on services, therefore, the chances are that your cost of living will rise more than the average – a lot more, over a couple of decades. If you budget for your spending rising in line with inflation, therefore, you might well find yourself struggling in your 70s or 80s.
Yes, it’s possible that robots will increase productivity in services and so reduce their prices. But do you really want to bet your pension on this?
Worse still, two things compound the danger here.
One is that the cost disease is especially severe for government services. The relative cost of services such as health and education tend to rise over time. This isn’t (just) because government is inefficient; the fact that private school fees have risen so much tells us that it is rooted in the very nature of the services. This means the tax burden might have to rise over time. Given that there are growing demands to address intergenerational injustices, the burden might fall upon pensioners; some serious economists have begun to advocate a wealth tax.
Secondly, social care is also prone to the cost disease. Its cost is therefore likely to rise over time. Some of us thus face the risk not just of needing social care, but that its cost will be much higher than it is now. (The Dilnot Commission proposed a perfectly good solution to this problem, but its ideas were never implemented.)
Worse still, we can’t rely upon our retirement income growing faster than our costs. Let’s say your wealth gives you an average real total return of 4 per cent per year with a standard deviation of 12 percentage points – which are reasonable numbers for a portfolio split 80-20 between equities and safe assets. Such a portfolio has a one-in-five chance of rising less than 3 per cent per year over the next 20 years. Which tells us there’s a good chance your wealth won’t keep pace with the particular inflation rate you might face.
What, then, can we do about all this?
One thing we can do is to buy before prices rise. If we have expensive holidays and nights out now we’ll build up a stock of happy memories which will give us comfort in years’ time when such things are unaffordable – or perhaps when ill-health means they are no longer so enjoyable. The problem with this, though, is that we might acquire expensive habits that are hard to break.
Another solution is to have cheap habits that are future-proof – ones that won’t rise much in price. This is my personal strategy: gardening, cycling, reading, walking and playing musical instruments are cheapish pastimes – though acquiring a collection of guitars is not.
A third possibility is to build in a margin of safety. If we spend less than our income early in our retirement we are in effect giving ourselves room for prices to rise.
None of these solutions is perfect. But this is because we face a massive problem: we are trapped between secular stagnation holding down returns on our wealth on the one hand, and Baumol’s disease on the other hand raising the relative prices of many things we enjoy. There’s no easy answer to this.
