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 can 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 and this is the silent killer.
The goal of every investor is to generate real, after charges and after-tax returns. Pretty simple stuff. The financial media spends most of its time talking about nominal returns. In a very real sense inflation and taxes play a more important a role on investor outcomes. We don’t tend to spend a lot of time talking about inflation rates and tax laws because they evolve much more slowly than market returns. Therefore our attention is drawn to market returns which as we all know are volatile.
It therefore is easy for investors to become complacent about inflation. (Let’s leave aside taxes for this discussion.) Ever since the end of rampant inflation in the 1970s and early 80s, inflation by and large has been off the table as an issue for investors and the economy
A lot of investors these days are holding large cash balances in the hope of riding out current market volatility. The problem is with the return on cash hovering around 0% in nominal terms and -2% in real terms, if you believe the inflation expectations, this puts investors in a pretty deep hole.
Most people are holding cash for a year or more in the hope of higher rates of interest. The reality is unless you are getting over 2.6% net (current rate of RPI) then you are guaranteed to lose money!
The worst outcome is the cash under the mattress strategy which will expose the investor to anywhere from 2% to 7% losses per year.
If you are holding large sums of cash over the long term this will almost certainly have a detrimental effect on your future lifestyle.