Last month, I delivered a series of retirement-planning talks to doctors. I had prepared a two-part presentation covering "How to quantify your retirement goals" and "How to design and maintain a retirement portfolio." I fully expected the attendees to be most interested in the investment topic, figuring that the markets may have done some damage to their portfolios and their confidence in the past year.

In fact, the doctors were a little shaken by their recent investment experiences; several confided that they had climbed aboard the technology bandwagon just before it swerved off the road to riches. One had lost half his money in a year! However, the attendees, who were in their forties, were especially interested in the goal-setting part of the talks. They wanted to understand how a retirement advisor goes about projecting how large a nest egg a person will require if he or she expects to enjoy a comfortable retirement. They wanted to know what assumptions they should make about inflation and rates of return, and the effect these assumptions will have on how much money they need to save each year to reach their goal.

I had prepared some slides to demonstrate the retirement arithmetic. One showed that we use a 7% average pretax return assumption so that surprises are more likely to be on the upside than the downside. Another slide showed how we adjust our future retirement-spending estimate for the impact of inflation. This is actually a hot topic for me, but I didn't expect my highly compensated audience to be so attentive as I projected a slide showing seven deflationary forces that I believe will make future inflation lower than the 3% we have averaged during the past 75 years. Here's why they were so interested.

What A Difference 1% Makes

If the United States should experience a lower rate of general price inflation in the next decade than it has during the post-World War II era, this would make a whopping difference in how much money people must accumulate to maintain their lifestyles during retirement. Here is an example from one of my slides. It shows the effect of inflation adjustment on a client's nest egg requirement and its effect on the annual savings required to reach that inflation-adjusted goal:

Dollars needed in 20 years to equal $1 million today
@ 3% Infl.: $1,806,000
@2% Infl.: $1,486,000
@1% Infl.: $1,220,000

Annual savings to get there @ 7% return
@ 3% Infl.: $44,000
@2% Infl.: $36,000
@1% Infl.: $30,000

So, a client hoping to retire in 2021 with the equivalent of $1 million in today's buying power would actually need to accumulate $1.8 million if we assume a 3% rate of inflation. Beginning from a standing start, this person would have to save $44,000 a year for 20 years and earn a 7% average annual return to reach that goal. However, if we could comfortably assume a 2% inflation rate instead, it would take only $36,000 a year in savings to achieve that buying power. At 1% inflation, the required annual savings drops to $30,000. By reducing your inflation assumption by 1% or 2%, you can enhance your client's current lifestyle by $8,000 to $14,000 a year. (Lower saving permits greater current spending!)

Put another way, if this same client is actually capable of saving $44,000 a year, by reducing the inflation rate to 2%, you would be able to project reaching his or her retirement nest egg goal 2 1/2 years earlier! At 1% inflation, he or she gets there in 15 years instead of 20 years. The rate of inflation is a very powerful number. If you make it too high, you penalize your clients' current spending unnecessarily. Make it too low, and they may reach retirement age financially unprepared.

Quick History Lesson

Using CPI data from the Bureau of Labor Statistics, I have calculated that the average annual rate of consumer-price inflation for the past 75 years is 3.1%. (A great inflation Web site is www.westegg.com.) Interestingly, the most recent 10 years saw the same average inflation rate. This pretty much explains why 3% is the inflation assumption preferred by most financial advisors.

But it is at least as interesting to know that from 1921 to 1961, consumer-price inflation averaged only 1%. That 40-year stretch included an investment bubble, a depression of historic magnitude, a world war and the rebuilding of Europe and Japan. From 1880 to 1920, every bit as colorful an era, the average inflation figure was 1.5%. Well, one might object, all that is very old data, and we might be better served using more current information. How about the last five years, which weighed in at 2.3%!

Seven Deflationary Forces

I am constantly reminding investors (and myself) of what I call the "first principle of investing," which is: "Nobody knows the future." This mandatory state of ignorance with respect to future events is the reason we diversify our investments across different asset classes that can be expected to react differently to future economic developments (that is, what the academics call "noncorrelated assets"). One of those things about the future that we do not know is whether inflation will be higher, lower or the same as our recent experience.

Actually, our uncertainty about the future cost of living goes deeper than that; we don't even know whether we will see inflation or deflation. Precious few advisors seem to think about deflation as a possible future scenario. Not since 1955 have U.S. consumers experienced an environment of falling prices for the goods and services that they purchase routinely. Consequently, there has evolved a working assumption that inflation is a constant reality in a world of paper currencies. But it isn't necessarily so. In Japan, the world's second-largest economy, consumer prices have been falling about 1% a year for nearly two years.

As a matter of fact, some pretty powerful deflationary forces are extant in the U.S. economy that could very well shatter the permanent inflation assumption, with significant implications for planning and investing. Here is my list of realities that seem likely to keep a tight lid on the selling prices of cars, clothing, housing, travel, engineering services, insurance, you name it.

Overcapacity
Globalization
Federal Reserve discipline
Boomer retirements
Baby bust
Productivity
Internet

Let's review them quickly.

Overcapacity. Just about every industry you can think of has excess productive capacity. In the wake of the technology-spending boom of the late nineties, U.S. factories are running at a very low 78% of their capacity. Retailers are cutting expansion plans and laying off employees. Hospitals have empty beds. And most of the fiber-optic cable installed in the last two years is still dark. In this environment, it is very hard for a vendor to raise prices for fear that a hungrier competitor will use it as an opportunity to grab market share. So when the cost of energy or labor rises, instead of price inflation, we see falling profits.

Globalization. It exacerbates the overcapacity situation. It's no secret that free-market capitalism is catching on all over the world; who wouldn't want to imitate what has worked so well in the land of the free and the brave? The next time you load up your Japanese SUV at Home Depot, check the labels. I'll bet half your purchases or more are marked "Made in China." Stop for some shirts and khakis at Old Navy, and you'll be looking at labels from the Philippines and Taiwan. With weakness in the euro, French wines have become competitive with the better California offerings. And the electric motors in your appliances are probably from Mexican border plants. Labor is less expensive in most places in the world, and even capital is sometimes cheaper (in Japan, for example). So goods from overseas are less expensive, and often they are as good as or better than the domestic alternatives. This trend will endure until world prices for labor and capital converge with ours.

Federal Reserve discipline. The inflation watchdog in the States is, of course, the Federal Reserve System. Mr. Greenspan has been singing the same price-stability tune to standing ovations for years, and I don't think he's going to change now. We can count on inflation wariness on the monetary front. And if by any chance Mr. G. or his successors should weaken, the world's "bond vigilantes" will be right there to enforce the discipline.

Boomer Retirements And Baby Bust. Demographics exert a powerful influence. We are all familiar with the effect of the post war baby boom on jobs, schools and consumer demand. Not everyone, though, realizes that a "baby bust" followed this big crowd. As one commentator puts it, the generation born between 1945 and 1965 decided not to replace themselves! During the last decade, the number of 40- to 59- year-old consumers in developed countries grew by nearly 15%, while the number aged 20 to 29, now entering their major consumption years, actually shrank by about 13%! The combination of the retirement of boomers (saving more and spending less) and the coming of age of the baby-bust generation (markedly lower demand that we have been used to) will be noticed from Battle Creek to Silicon Valley.

Productivity. We are used to thinking of technology as a stimulant to economic growth, which of course it has been. But it also has a profound influence on the productivity of our work force and efficiency of our factories and offices. Not only does more efficient production have a salutary influence on selling prices, but as we purchase more electronic products, the benefits of Moore's law also become more pervasive. An engineer told me recently that there is more computing power in his late-model Buick (+/- $30,000) than was used to land Neil Armstrong on the moon in 1969. Technology definitely is deflationary.

Internet. The explosion of Internet usage influences prices in a different way. It reduces friction in the exchange of goods and services. It creates an open market in which the prices and quality characteristics of goods and services are on display to the whole world of potential consumers, as well as competitors. In a world in which comparison pricing is this easy, it is decidedly more difficult for a vendor to sustain premium prices, and it gives an advantage to companies willing to work on smaller margins. Do you suppose that book prices might be higher if they were not available from Amazon?

Decision Time

So I ask myself, what is the responsible thing to do with all this information? Do I reduce my inflation assumption when I run long-term cash-flow models in my retirement projections? And if I do that, shouldn't I ponder the influence of inflation on long-term investment-return assumptions? The 75-year average return on large-cap stocks is something like 11%, of which 3% is inflation and 8% "real."

Will a change in our inflation experience have a similar influence across all asset classes? During the inflationary 1970s, returns were below average for stocks and even worse for bonds. During the Great Depression, when the CPI fell about 25%, the only productive investment class was risk-free government bonds.

As with everything that has to do with the future, the only true answer is, "I do not know." Yet my job is to help clients cope with that perpetual state of uncertainty. When it comes to assumptions about living expenses, I have decided to reduce my 3% working inflation assumption to 2.5% for the time being. My conviction is that even this will turn out to be too high, but it is such a powerful number that I want to approach it with extra caution. Caution could suggest leaving the figure at 3%, but I would rather move in the right direction than ignore the substantial evidence.

J. Michael Martin, JD, CFP, is president of Financial Advantage in Columbia, Md.