"Originally the motivation for introducing the CPI-E was precisely so that Social Security might be linked to this index," says
Milevsky. "At this point though, I don't think the U.S. can afford to link to yet a higher CPI-E."
Milevsky calculates that during the period from 1982 through 2006, CPI-E averaged 3.3 percent, versus 2.96 percent for CPI-W, or
one-third of a percentage point higher annually.
This is true even though seniors spend less on just about every component of the index except for housing and medical care. In
fact, they spend twice as much on medical care as younger workers.
Except for those who've been in a coma obliviously racking
up bills, everyone is aware that medical costs
have risen at a much higher rate than most other
goods and services. So, not surprisingly, the
inflation rate that seniors experience is higher
than that of the population at large.
In a separate paper published in
December, titled "Should Retirees Insure Against
Inflation or Just Worry About It?," Milevsky and
co-author Huaxiong Huang make the case that CPI-linked
investments such as Treasury Inflation Protected
Securities, or TIPS, and I-bonds are not perfect
ways for retirees to hedge against "retirement
ruin" -- a scenario in which a retiree's money
runs out before his or her life does.
Their paper discusses how much retirees might allocate to an imperfect hedge, such as TIPS and I-bonds, versus an equity fund,
with varying assumptions about the volatility of the investments and the probability for ruin at different allocation levels. It's not easy to
sum up in a few lines, so I won't. But here's the line that struck me: "Obviously, as the wealth to liability ratio increases, the entire vector
of ruin probabilities declines and reaches zero at approximately 50-to-1."
Translation: You won't have to worry about how you allocate your assets among imperfect inflation hedges and stock funds if
your assets are 50 times higher than your current level of consumption.
So if you need $75,000 a year to live comfortably, in addition to your Social Security payout, a nest egg of $3.75 million
will ensure a worry-free retirement during which you need not pay too close attention to your finances.
Immediate annuities with COLAs
Let's face it, most of us won't be able to save 50 times our annual salary, or even 25 times for that matter. So we can buy annuities or some
other financial products designed to last for the duration of our lives -- though we must do so with utmost care.
For instance, would it make sense to purchase an immediate annuity with a built-in COLA increase of 3 percent annually?