Are your investment returns real?

Amidst the more obvious lingering effects of a sluggish economy, such as slow job growth, decreasing incomes, low interest rates and shaky consumer confidence, there lurks a more insidious threat which has largely been ignored. Inflation or the prospect of its resurgence has somehow remained under the radar; perhaps because the official measure, the Consumer Price Index (CPI), is still below historical averages, or perhaps because the government has done such a good job in convincing the public that inflation is not a real threat at the moment. 

While declining paychecks and near-zero growth savings accounts are the tangible results of the current economic and fiscal environment, inflation is the ever-present hidden tax. In real terms this creates a critical perception gap between what people see as their “nominal” income, that which they can see in their checking and savings accounts, and their “real” income they can actually use to buy gas, groceries and insurance.  That perception gap can mean the difference between planning for a secure financial future and one that falls well short of satisfying your financial needs. 

Nominal vs. Real Income Explained

The most familiar use of the terms “nominal” and “real” in describing income is with government and corporate accounting methods. For instance, when a company reports earnings growth of six percent, it is typically stated in nominal terms on its financial statement. However, when it is measured in real terms, it is adjusted for inflation. The company reports nominal income because it creates a better perception; however, for planning purposes, it uses real income so it knows what its actual capacity is for buying new inventory, producing new goods or hiring new staff.

The same concept applies to consumers, except they generally live in the “nominal” world based on what’s reported in their W-2s and deposited into their checking accounts. What they don’t see it the effect of inflation on their purchasing power. With an inflation rate of 3 percent, a basket of goods that cost $100 last year will cost $103 this year. That may not seem like a lot, but 3 percent compounded year after year means the cost of that basket will double in about twenty four years. 

The real problem is that inflation measured by the government’s CPI is not necessarily the inflation that most people are experiencing. That’s because a few of decades ago, when inflation was spiraling out of control, the government removed food and energy prices from the basket of goods because “they were too volatile.” When those items are added back into the real life basket of goods most people consume, the “real” inflation rate is closer to 10 percent. So which inflation rate should you use when planning your future?

Consider how your nominal and real incomes are impacted by the real rate of inflation over a period of time. If your after-tax nominal income for 2013 is $80,000 and is increased by the cost-of-living as measured by the CPI, say 3 percent, it will grow to 82,400 in 2014. But, if the price of the basket of goods that you normally purchase increases by 10 percent, your $82,400 of income will only buy what $74,000 of income would have purchased in 2013. In reality you will suffer a loss of real income. When the same assumptions are extrapolated over 20 years, the loss of real income is compounded with potentially disastrous implications.

The Impact on Savings

The implications of nominal and real numbers become even more significant when they are applied to savings and other interest-bearing investments. Many investors are relying upon their savings and investments in bonds to provide a secure source of retirement funds. As a result of the sluggish economic conditions and the monetary policies of the Federal Reserve Bank, the yields on secure investment have been driven down to record low rates. A certificate of deposit may pay 1.5 percent interest in nominal terms; however, in real terms, after inflation, the real rate of return is arguably negative.

Summary

For many people directly affected by a weak economy, it may be bad enough to look at their finances in nominal terms.  It is even more uncomfortable to address the reality of their real income today and growing expenses in the future.  But, even those who have not been meaningfully impacted, looking at their future through nominal lenses can lead to a financial plan that comes up well short of their objectives.  Whether you will continue to work to maintain your standard of living or expect to retire soon, your planning needs to consider both your nominal income and investment returns compared to the real and expected expenses.