Abstract Purchasing Power of Investments

A friend of mine made a comment this weekend about his deferred compensation retirement statement. A new statement arrives quarterly showing profits and losses in the retirement account denominated in US dollars. This got me thinking about the differences between the dollar amounts shown on a retirement statement, brokerage statement, or the value of any investment compared to the purchasing power of dollars spent today.

This post is mostly rambling hypothesis and conjecture, but it puts purchasing power at a particular point in time in some kind of perspective. It seemed somewhat interesting rolling around in my head and writing it down helps flesh out the idea.

Purchasing Power in Time

The purchasing power of a US dollar fluctuates continuously based on many factors. For any given product or service, the current price is the intersection of the supply of and demand for dollars with the supply of and demand for the product or service. Since that intersection moves continuously, it can vary over time, and it can vary immensely over a long period of time. Note that part of the supply and demand profile for dollars is reflected in foreign exchange rates. For humans, a long period of time can be the 30 years that retirement funds are locked up (severe penalty if withdrawn) before retirement.

Here are a few consumer prices from the BLS from 30 years ago (US City Average):

Bread, white, pan, per lb. (453.6 gm)
1981 0.53
2010 1.38

Electricity per KWH
1981 0.063
2010 0.125

Gasoline, unleaded regular, per gallon/3.785 liters
1981 1.298
2010 2.985

Prices of some items have roughly doubled over 30 years, and some have more than doubled. On the other hand, prices of things like computers have come down by orders of magnitude.

Liquidity and Taxes

Going back to the retirement account statement, what is the purchasing power of those dollars today? That money is not liquid, it must be extracted with penalties from the account and taxes paid on it (unless it is a Roth IRA), then adjusted for inflation (zero inflation if you spend it today). For a traditional retirement account, a rough estimate is 40% of the purchasing power is destroyed through penalties, state, and federal taxes. So the purchasing power today is about 40% less than what appears on the statement. After some period of time, the penalties go away, but the taxes remain, perhaps at a lower rate if your income is lower during retirement. Over that time, inflation has probably eaten some purchasing power. The point is that the purchasing power of retirement account dollars are very abstracted from the purchasing power of dollars today.

Inflation, Productivity, and Technology

Let's turn our attention to the forces operating on the purchasing power of dollars over time. Inflation and deflation are the source of many misunderstandings and issues, mainly due to different definitions and ways to measure it. I prefer to think of inflation as the net effect of changes in money supply and velocity, one result of which is higher or lower prices. Higher prices mean lower purchasing power. Inflation is always working against you, while always working for governments.

Fortunately, there are forces working in everyone's favor to increase purchasing power. Those forces are productivity and technology. Both tend to increase output per labor hour and/or reduce operating expenses, creating downward pressure on prices. Computers are a perfect example. Moore's law suggests that microprocessor power doubles every 18 months. That is equivalent to a 48% deflation rate (or negative 48% inflation)! Massive increases in productivity and technology are what keeps inflation at bay. It creates the illusion that the Fed is doing a good job managing inflation and the dollar, when in fact, it is all the deflation created by entrepreneurs and technology that lets people flourish.

Thinking back on the retirement dollars, if productivity and technology can outpace inflation over 30 years, those dollars become more valuable later. But since inflation has no upper limit in a pure fiat system, I would bet on inflation winning in the long run.

Demographics of Conventional Investments

One final thread to this idea. That is the effect of the baby boomer generation on conventional investment vehicle prices. Since the 1970s, conventional wisdom has been to invest primarily in stocks and bonds through IRAs and 401k type plans. Without trying to calculate the effect of the majority of boomers buying stocks and bonds, sheer numbers say there should be an upward price movement due to increased demand. All things being equal, as boomers begin to liquidate their stocks and bonds during retirement, there should be downward price pressure as sellers outnumber buyers. One caveat is that foreign buyers could step in to fill the demand. If not, then lower prices for financial assets mean lower purchasing power during retirement. That doesn't mean you should necessarily stay away from stocks and bonds, but it is a factor to consider in any kind of long term planning.

Purchasing Power Pressures

Pulling it all together, the purchasing power of retirement account dollars in the distant future are very hard to measure. Inflation and taxes will eat away at it, productivity and technology improvements will increase its value over time, and demographic effects for conventional investments may decrease purchasing power over time. Whether the numbers on a retirement statement today have a strong correlation to their purchasing power many years in the future is difficult to say.