Trying to hit your retirement savings target is a daunting task at the best of times, but when that target begins to move, the task quickly begins to feel impossible. Taxes slowly devour retirement nest eggs, moving the target and forcing you to save more money than expected. Explicit taxes, or the taxes we see on our pay slips, are obvious. They generally rise, but they can be reduced by using investment strategies. However, there is another kind of tax - a hidden, implicit tax that can be much harder to spot and much harder to deal with. This hidden tax is inflation.

Tutorial: Investing For Safety And Income

Inflation affects the price of everything from socks to stocks and can make it hard for potential retirees to gauge how well they're doing in terms of savings. Read on as we explore this silent retirement killer and show you how you can prevent it from snuffing out your retirement dreams. (For more on the problem of inflation, check out Curbing The Effects Of Inflation and What You Should Know About Inflation.)

History of a Killer
It has been the informal policy of the U.S. central bank - the Federal Reserve Board, or the Fed - to tolerate inflation. Instead of trying to eliminate inflation, the Fed tries to limit this unpredictable foe to 2-3% or less. This policy succeeded in the 1990s, when inflation was low, but failed in the 1970s, when it was often in the double digits (see Figure 1).

The Unpredictable Nature Of Inflation
1970s 1990s
1970 5.85% 1990 5.39%
1971 4.30% 1991 4.25%
1972 3.27% 1992 3.03%
1973 6.16% 1993 2.96%
1974 11.03% 1994 2.61%
1975 9.20% 1995 2.81%
1976 5.75% 1996 2.93%
1977 6.50% 1997 2.34%
1978 7.62% 1998 1.55%
1979 11.22% 1999 2.19%
1970 average 7.09% 1990 average 3.01%

Figure 1

Source: U.S. Department Of Labor

Given that inflation is persistent, potential dangers abound. What this boils down to is we cannot know with certainty whether the Fed or any central bank will effectively manage inflation. Therefore we cannot know exactly what the inflation rate will be.

Still, based on history, we know inflation must be a factor that every sage person preparing for retirement must consider. We also know that the increasing costs triggered by inflation mean a once-safe amount of money designed to ensure a comfortable lifestyle, can become not so safe 10-20 years into retirement. (To learn more about what causes inflation, see our Inflation Tutorial.)

The Financial Challenge
Let's say you retired with $1 million in 1976. A million bucks! You've got it made, right?

Not so fast. Something happens to those dollars while you were busy playing golf and enjoying retirement. Inflation averaged 4.33% per year over the next 30 years. Using the U.S. Department of Labor's Inflation Calculator, by 2006, you had to have $3.56 million to match the buying power of $1 million in 1976. Let's take another example and begin with $1 million in 1986. Over the next 20 years, inflation was a little more manageable. It averaged 3% per year. So, you would have needed $1.89 million in 2006 to match the power of $1 million in 1986.

This loss of spending power can become a huge problem. The key to survival is making investments that outpace taxes - both seen and hidden.

Stocks for the Long Run
Over the long term, stocks and stock funds tend to have returns that beat inflation. "Stocks turn out to be great long-term hedges against inflation even though they are often poor short-term hedges," writes Jeremy Siegel in his famous book "Stocks For The Long Run" (1994). (To learn more on the importance of stocks in retirement planning, read Weave Your Own Retirement Safety Net.)

Financial advisors say that just about all retirees, especially those retirees who may have another 30 or 40 years, should own at least some stocks. To begin one must understand the concepts of nominal and real returns. Nominal returns tell us what an investment has returned before inflation.

Example - The Importance of Real Returns
Say you are earning 5% on a bond. But, in the same year, the inflation rate is also 5% - high by recent standards but low by the standards of the 1970s and \'80s. You see the 5% return on the bond and probably think you\'re ahead, but in reality this is not the case. In fact, you probably aren\'t even breaking even. If you paid explicit taxes on the 5%, then you are actually at a loss. Real returns tell us what an investment gained after figuring the implicit tax called inflation.

Fixed Income Can Equal Fixed Losses
Those who don't want to "take a chance" with their retirement savings often put their money in the guaranteed returns of bonds. However, this can be a huge risk. Bonds usually lag inflation so one risks losing buying power. (For more insight, see Common Mistakes By Fixed-Income Investors.)

Historically, stocks as a group have strong real returns, but they aren't foolproof. Stocks are generally a better long-term bet, but many advisors, who emphasize some stocks in almost every portfolio, also believe that a part of one's assets should be in bonds.

The Case for Bonds
Why bonds? Stocks are great long-term hedges against inflation but their volatility over the short term can lead to problems. Stock prices move up or down quickly. This makes them unpredictable when the market dips.

This means that sometimes bonds beat stocks. Bonds and stocks are different classes of investments that tend to move in opposite directions. No one can know exactly when bonds will be winners and stocks will be losers. All we can say is that stocks usually beat bonds, but usually is not always. Indeed, 2002 was a terrible year for stocks, with the average domestic stock fund losing 21.28% according to data from Morningstar. How did bonds do in that same year? They were up 7.55%.

Conclusion
Taxes and inflation are tough to beat, but this is a very important concept that must be understood by those looking to retire in the near future. A simple retirement planning strategy such as using both stocks and bonds may be the most logical way to beat inflation.

For related reading, see Bear-Proof Your Retirement Portfolio and Inflation-Protected Annuities: Part Of A Solid Financial Plan.

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