The Conversation about Inflation-Risk is Dead Wrong

This is an updated excerpt from my book, Financial Sobriety; Rebuilding Your Relationship With Money One Step at a Time.

When I was eighteen years old and headed off to college, we did not have email or smartphones to communicate with friends and family. I used to call my parents collect from a payphone at the end of the hall in my dormitory for 10 cents a minute. I used to write my girlfriend love letters and send them to her in the mail. In 1990, it cost me 25 cents to mail a letter to her. My sophomore year of college, postage rates increased to 29 cents. A year after graduation, the price of a stamp increased to 32 cents.

As of October 2021, the cost of a U.S. postage stamp is 58 cents. Using the Rule of 72, we can easily calculate the rate at which the price of a U.S. stamp has increased since my college days— approximately 3 percent a year. That doesn’t sound like much, but over time, that annualized price increase can be significant.

The reason I chose to highlight the increase in prices for postage stamps is because they are representative of the long-term average price increase for many of the things we spend our money on: clothing, transportation, most household items, and a lot more. Some years price increases are higher, some years they’re lower. But over long periods of time, 3 percent has been the historical norm for lots of things we spend money on. Once more applying the rule of 72, this means that our income and our savings accounts have to double every twenty-four years just to be able to buy us the same stuff in the future that we buy now.

Inflation means that over time, the cost of “stuff” goes up and our savings and paychecks need to beat or exceed the rate at which “stuff” costs more over long periods of time. Inflation is measured in a number of ways. The most common form of inflation is measured by what’s called the Consumer Price Index (CPI). The CPI measures the growth rate of items consumers spend their money on, minus food and energy cost. It’s important to know that CPI is an average that covers many things. Specific things like college education and healthcare see much greater than 3 percent inflation rates year in and year out. Other things like TVs and computers have seen negative inflation, meaning prices have actually decreased over time. But put it all in a blender and we can expect to average 3 percent inflation over our lifetime, despite the spikes we occasionally see, like the one we're experiencing right now.

Success or failure in keeping up with the rising cost of stuff is called inflation risk. Inflation risk is something every worker and retirement saver needs to protect themselves against.

This is one of the hottest topics being discussed online and in the news today. But is it the right way to be discussing inflation?

Wall Street and the financial services industry have done a good job educating investors on how inflation can erode one’s purchasing power over long periods of time. Many investment tools have been created to help people grow their investment savings in an attempt to outpace inflation.

But there is one side of inflation Wall Street, the financial services industry, and the megla-media machine do not spend enough time addressing and helping people with.

It’s called lifestyle inflation, and it's the official term for ‘keeping up with the Joneses" - the more useful conversation about inflation we need to be having because it's been a silent ongoing phenomenon for some of us for our entire adult lives.

Think back to your first full-time job. Do you remember your starting salary?

My first full-time job in 1995 was as a stockbroker trainee and my initial salary was $22,000. Paying my bills every month wasn’t easy. There was barely any money left over to have fun or treat myself to a weekend splurge. I remember thinking often about how much better life would be if I were able to just manage a small pay raise and live more like everyone else I see out there having fun and buying lots of cool stuff. When I found my next job a year later working for a small mutual fund manufacturer, my salary was increased to $25,000. A $3,000 pay raise was something I was proud of. Naturally I wanted to reward myself for working hard and finding a new job that paid me more. With that pay raise, I found myself eating out more and treating myself to little “extras.”

As time went on, I continued to see more significant pay raises. With each pay raise came rewards: a nicer car, a bigger house, fancier suits, more expensive meals; all the necessities for keeping up with everyone around me. By the time I was thirty-three years old, my pay had increased over 2,000 percent from my initial $22,000 salary and my lifestyle had certainly reflected the massive pay increase over time. I felt like I was now Mr. Jones himself!

My income had outpaced inflation by a long shot—only now my financial obligations had become much greater and way more complex, thanks to my desire to keep up. I owned a much bigger home, which meant higher utility and maintenance. Of course, we had to hire a gardener and house cleaners, since everyone else in the neighborhood did this, too. Since the new home was bigger, it seemed appropriate to buy more furniture and decorations to fill the empty space. My new European sports sedans also came with higher costs of ownership: high-test gasoline and maintenance costs like synthetic oil changes and high-end brake replacements.

Despite seeing my income grow much faster than 3 percent inflation, I ultimately found myself in the same exact place I was when I was twenty-two years old with a $22,000 salary: able to pay my bills but with little in savings to show for all my efforts. Despite having much nicer stuff, the respect of the Joneses, and a whole bunch more financial complexity in my life, the one thing I did not have more of was money in the bank or significantly more in retirement savings.

Lifestyle inflation is the single greatest risk to one’s financial security. Experience has taught me it’s much more dangerous than the risk of core inflation. But the good news is that, unlike core inflation risk, lifestyle inflation is something we have 100 percent control over.

Most new clients I meet tell me they have experienced lifestyle inflation. I often meet people who make lots of money and they tell me they have no idea where it goes every month. The list of financial obligations they bring in for review is daunting. House payments, private school tuition, country club memberships, credit cards, multiple lease payments for cars, RV's, and boats—they often feel overwhelmed, stuck, and unable to see how to unwind this high rate of lifestyle inflation that’s now suffocating them.

I start by reminding them they’re not alone, that I’ve been where they are, as have so many others. But now, unlike most people, who never learn about lifestyle inflation until it’s too late, we get to change behaviors, unwind the complexity that’s been created, and start to reverse the damaging effects lifestyle inflation will continue to have on their future financial security.

If the best time to plant a tree was twenty years ago, the next best time is now.

What I mean by that is, once we become aware of the damaging effects of lifestyle inflation, we can choose to make smarter choices starting right now.

Pay raises going forward can be directed into savings instead of spending. Instead of using the next pay raise to keep up with the Joneses with vacations, nicer cars, and home improvements, the increased net amount received in your paycheck could be automatically swept into one form of savings for the future. If your emergency savings is less than six months’ worth of living expenses, then I recommend we start there. Once six months’ worth of living expenses are set aside, then we can start using the pay increase to add extra funding to your financial vehicles of choice, like a 401(k), IRA, Roth IRA, or cash-value life insurance policy.

I am all for enjoying a nice vacation or paying for some upkeep on a home. But these are items that can be funded with some planning and disciplined savings strategies rather than just being absorbed by annual pay increases. Perhaps a portion of your pay raise can go toward discretionary spending. But I have learned firsthand that real financial security often comes from having six to twelve months of income saved, and enough retirement savings accumulated to create thirty or more years of retirement income. It does not come from having lots of nice stuff.

Lifestyle inflation comes mostly from our need to keep up with the Joneses. Most of us succumb to it at some point in our lives. Our neighbor buys a new car, then so must we. A friend posts pictures on social media of a lavish Hawaiian vacation and so we book a similar trip for our family. Comparison is the foundation of all unhappiness and our desire to keep up with the Joneses ultimately becomes our financial downfall.

Inflation risk is real. But the price at which things we purchase increases is completely out of our control.

Lifestyle inflation, which has a much greater effect on our financial security, is the one aspect of inflation risk we have complete control over.

Forget the Joneses. Take care of yourself and your family. I promise one day you’ll be grateful you did