5 Reasons Why Deflation Is Good for Retirees

Fixed incomes go further as prices and interest rates decline.

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Living on a fixed income is looking downright sexy these days. Consumer and commodities prices are headed south, and inflationary pressures have gone way underground. Toss in the 5.8 percent cost of living rise in Social Security next year—the largest annual increase since 1982—and it may be party time in some circles.

There are no sure things, but if the recession is as steep as forecast, then prices are not rising anytime soon—short of natural or man-made catastrophes. Consumers, who generate 70 percent of consumption in the U.S., simply are not buying. So, we're looking at anywhere from six to 18 months of flat or falling price levels. Now, that's either deflation—prices actually fall—or disinflation—prices increase at a decreasing pace. Either way, it is not the kind of economic death spiral that would occur if deflationary forces took long-term hold. That picture is ugly—declining demand causes business layoffs, causes further shrinkage of income, causes even less consumption, etc.

The prospect of short-term deflation has silver linings, particularly for retirees who are not worried about losing a job and have access to Social Security, defined-benefit pensions, and other stable sources of financial support.

"In some sense, deflation is an ideal environment for someone who is on a fixed income," notes Dean Croushore, an economist at the University of Richmond's Robins School of Business. "Part of the story is good news," agrees Boston University economist Laurence Kotlikoff. With deflation, "the price of consuming in the future becomes cheaper. You have to put aside less money today to consume in the future."

Tips for a deflationary world:

Decrease your debt. Accelerate debt payments. "If there is deflation, you will be paying them off with more expensive dollars," Croushore says.

Restructure your debt. Interest rates on everything will decline, so it's a good time to restructure your debts. "If you do get a sustained period of reduced prices, you will really see low nominal interest rates on everything," Croushore says.

Refinance your home. "Everything else being equal," Kotlikoff says, "deflation should lower mortgage rates." Together with government-backed mortgage supports, this will be a good opportunity to refinance a home and sharply reduce monthly payments. Lower house payments traditionally support higher home sales prices, so deflation will be good for housing values so long as it doesn't depress economic growth too much, which would be bad for home values.

Buy TIPS. Treasury Inflation-Protected Securities, better known as TIPS, make a lot of sense for stock-averse investors, especially those who fear both a low-inflation environment over the next couple of years and higher inflation as the economy recovers. At 3 to 4 percent, "the TIPS return is quite impressive right now," Kotlikoff says.

TIPS pay a fixed interest rate but the principal of the bond changes to reflect inflation, as measured by the consumer price index. So, if the CPI rises, so does the principa of the bond, meaning that interest payments would rise and afford inflation protection. If prices fall, the principal amount of the bond would fall as well, but it can never fall below its face amount when issued, so holders are protected against deflation as well. TIPS are exempt from state and local income taxes. Outstanding bonds have maturities out to 2032, there is a liquid trading market, and auctions of new TIPS occur several times a year.

Buy inflation-protected annuities. Older investors should consider locking in future income streams and guarding against inflation by purchasing inflation-indexed annuities. For many people, Kotlikoff says, the cheapest way to do this is by reapplying for Social Security. Social Security payments are available at age 62 and lots of people begin taking them as soon as they can. But a person's maximum payment rises each year until their 70th birthday. Those annual increases average a hefty 7 to 8 percent a year plus whatever annual cost-of-living adjustments are provided to beneficiaries.

Persons who have taken Social Security before the age of 70 can pay back their accumulated payments, without interest, and then reapply for Social Security and receive payments at the higher level associated with their current age.