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Most people know what inflation is, but few truly understand how inflation can hurt them, especially when they’re saving and preparing for retirement. Quite simply, inflation is the measure of how much the things we buy increase in cost each year. During the past 30+ years, the inflation rate in the United States each year has ranged from less than 2% to more than 15%, with an average of more than 3.7% per year, compounded. That means that, with few exceptions, the cost of the things we buy goes up consistently.

Despite this fact, we hear relatively little about our needing to plan for inflation when thinking about retirement. That is unfortunate because having inflation is actually U.S. government policy. What that means to you is that you need to plan for the purchasing power of the U.S. dollar, our currency, to decrease each year.

In many respects, inflation is a double-edged sword. On the one hand, if prices rise continuously, it spurs people to buy things before the price goes up. So the inflation policy is actually meant to spur consumption, which is good for the economy. On the other hand, inflation hurts people when they’re planning their retirement because most don’t recognize how even moderate inflation impacts their future income needs.

Planning for Retirement

For example, if you need $30,000 a year from your investments today to maintain your lifestyle (in other words, $30,000 of purchasing power), and the inflation rate stays consistent at 3% per year, in 10 years you’d need more than $40,000 a year to maintain the same standard of living that $30,000 buys you today. In 20 years, assuming the same 3% per year inflation rate, you’d need more than $50,000 a year just to maintain your current purchasing power.

The fact is that today’s low interest rates on money market funds, savings accounts, and bonds, along with the stock market’s low yield, force millions of seniors to spend their savings, some to the point of bankruptcy. Clearly, this is a real problem.

Therefore, if you think only in terms of what income you need on the date you retire, you are making a major mistake. To have true financial independence in our inflationary environment, you need to plan to maintain your purchasing power, indefinitely. To do that, you need to find a way to have growing income. Common stocks are the best vehicles for investing for growing income, but not all common stocks!

Investing for Growth-of-Income

If you’d like a proven way to invest your savings for generous, growing, spendable income—so you only spend the growing income each year and don’t invade capital—consider the following process:

• For growing income, invest only in the stocks of companies that have at least 10 years of never-decreasing dividends, and higher-than-average yields.

While you may think that finding any company with a track record of 10 years of never-decreasing dividends is like finding a needle in a haystack, the fact is that there are literally hundreds of companies that meet this criterion. The Yahoo Finance Stock Research Center website has a Historical Quotes feature that lets you see a company’s dividend history. Looking back 10 years is long enough to make certain that the company’s management values paying increasing dividends.

• Once you identify some companies, do your homework on them.

When choosing companies to invest in, use online resources, such as MSN’s MoneyCentral website, to learn about a company’s prospects. Use the link they provide to go to the company’s website, where you will find the current and earlier year annual reports.

In order to have peace of mind when investing, you need a thorough understanding of the company you’re investing in — what they plan to do in the future as well as what their management has accomplished in the past. You need to have confidence that management can implement their stated plan and achieve the goals they’ve set for the company. Therefore, as you analyze companies, think of it as an investigative process. Read the Chairman’s Letter to Shareholders in the annual report each year, and look at the company’s revenue history, earnings history, earnings per share history, and dividends per share history. These are all vital indicators of the company’s overall health.

For example, if you see that a company is increasing their dividends by 11% per year, on the surface that sounds promising. With some more investigation, though, you may find that the company’s revenue is growing by only 2% each year. Earnings growth ultimately has to come from revenue growth. Companies can cut costs for a while to grow earnings, but if they cut back costs too much, the changes will become apparent to customers and they’ll lose business. So it’s an unsustainable model and a company you’d want to avoid.

• Choose as investments those companies that appear likely to have dividend growth that will give you the highest yield in five years.

Many people who choose investments make a guesstimate of what the company’s future earnings per share is likely to be. But they don’t go to the next step to estimate what the company’s dividend appears likely to be in the future. Without this information, it’s difficult to invest wisely for growing income. Therefore, call the company’s investor relations department and ask them to ask the Chairman of the Board what he or she feels the board will want the dividend payout ratio to be in five years based upon what the company has done historically. Then you can apply the company’s estimate of its payout ratio in five years to analysts’ estimated earnings per share growth for five years. Is this 100% accurate? Of course not. No one can predict the future with certainty. But if you’re choosing companies that have paid dividends for the past 10 years or more and have consistent revenue growth, you can feel it is highly probable that the company’s management is forecasting to the best of their ability.

To have true financial independence in our inflationary environment, you need to plan to maintain your purchasing power, indefinitely.

• To ensure that your savings last longer than you do, plan to spend the income on your investments, not your capital.

If you think that taking only $30,000 from your capital each year is not a big deal, think again. Reverse compounding works just like compounding does…but in reverse. For example, suppose you have $500,000 in capital. You were unaware that investing for growth of income was possible, so you invested your money in a Blue Chip stock portfolio. Unfortunately, the market stays flat or goes down, as it did over the past decade. Your dividend income from your investment might only be $10,000 (2%) per year. But you need $30,000 to maintain your standard of living. So you sell $20,000 worth of your stocks (4% of the portfolio’s value) to live on the first year. Now you have less capital-producing dividend income, so your dividend income next year might well be less than $10,000, and you have to sell more than $20,000 of your portfolio. When you deduct more than you’re earning, the percentage you’re withdrawing keeps going up. It is a reverse compounding process, where your market value shrinks at an increasing rate.

Create Generous, Growing Investment Income — for Life! 

The growth of the aging population in the U.S. has shown that the Social Security system cannot continue to provide in the future the kind of benefits it has thus far. Therefore, the message is clear: each of us needs to plan for having the growing income we need when we retire. Fortunately, investing for growth-of-income is something anyone can do, provided that you are motivated to want to invest well. Ultimately, when you implement these suggestions, you can have growing income for life, regardless of what the stock market or interest rates do.