Cost-of-living adjustments in contracts and laws are woefully inadequate to protect you from inflation and hyperinflation

Many things are indexed these days: some laws, long-term leases, long-term labor contracts, Social Security, government pensions, Treasury Inflation Protected securities (TIPs), and so on.

Why?

To protect people who pay or receive money from inflation including hyperinflation.

So are they protected?

Hell, no!

Why not?

1. income taxes
2. hyperinflation moves too fast for adjustments based on published changes in the Consumer Price Index

No real gain but you have to pay a real tax

Your basis in an asset is not indexed for the purpose of calculating capital gains when you sell it. Only the U.K. and Australia index basis for capital gains tax calculating purposes.

Let’s say you own a $200,000 home. It does not go up in real value one penny over two years until you sell it. But because the purchasing power of the dollar dropped by 10% during that period, your sale price is $200,000 x 110% = $220,000.

How much real (adjusted for inflation) gain have you experienced? Zero. The house is now worth 10% more in dollars, but so is a gallon of milk or anything else you buy. Your house did not go up in value really, but the IRS says you owe a capital gains tax on that $20,000 “gain.”

If you complain to your congressperson, he or she will probably point out that your tax bracket and dependent exemptions and a number of other things are indexed for inflation. True, but that won’t do you a damned bit of good with regard to the tax on your $20,000 “gain.” The government will take 15% of that in 2010 or $3,000. So you are $3,000 poorer in a real (after adjustment for inflation) sense.

Tax robs your TIPs bond of its inflation protection

Treasury Inflation Protection securities, also knows as TIPs bonds, are supposed to protect you from inflation.

Do they?

Hell, no!

Why not. They adjust your principal twice a year. If there was 10% inflation in a year, and your bond were originally $100,000, it would adjust 5% at the first six-month point and another 5% at the second raising the balance owed you by the government from $100,000 to $110,000 BEFORE TAX.

But that adjustment is taxable (by the federal government only). As with the house example above, it’s not a real gain or real income. All that 10% adjustment reflects is that the government printed too much money during the year. But the “fine” you have to pay for your government printing too much money is your tax bracket multiplied by your inflation adjustment. Both the interest you get and the adjustment to your principal amount for inflation are taxed as ordinary income, not capital gains! Plus, you do not actually get the principal adjustment amount until maturity. That is, you have to pay tax now on money you do not receive until later.

Nowadays, if you are affluent, that means you will get hit with a tax in the 40% range after Obama imposes his Medicare tax increase and lets the Bush tax cuts expire.

So do Treasury Inflation Protected securities protect you from inflation? Before tax, they protect you from moderate inflation, but after tax, you’re screwed out of close to half of your protection.

Virtually all incremental amounts you receive from adjusting your income for inflation are taxed thereby cutting your inflation protection approximately in half. That applies to everything, not just TIPs bonds.

You even get screwed if there’s DEFLATION!

Sometimes, you even get screwed tax-wise when we have deflation. That happens when the tax brackets are two-way indexed, that is, the adjustment applies to both inflation and deflation.

For example, for the 2009 tax year, your bracket jumped from 25% to 28% when your income went above $137,050. If there was deflation, that trigger income level would be adjusted downward, say, to $130,000. So if your income were between $130,00 and $137,050, you would get a 3% tax rate increase from the purchasing power of the dollar going up, not because you got a raise.

These sorts of problems, and how to protect yourself from them, are discussed in greater detail in my forthcoming book How to Protect Your Life Savings from Hyperinflation and Depression.

Way too slow

But wait! There’s more!

Suppose the cost of living goes up really fast? Faster than it has gone up since the Greenback dollar and Confederate dollar during the Civil War? As fast as the hyperinflation in Weimar Republic Germany in 1922 and 1923?

Are you protected by the various cost-of-living clauses in laws and contracts?

In your freaking dreams!

Take Social Security. It’s indexed right? So no problem.

Think again. They adjust it annually. Annually!? What if the inflation rate is 20% per year. By the time they get around to doing the once- a-year adjustment, you’ve had to suffer through months of lower purchasing power.

What if inflation is 445% per year as it was in Israel in 1984? At that rate, here is what happens to the price of a gallon of milk that starts at the current price of $3.

445% x $3 = $13.35 That’s a $10.35 price increase in a year; $86¢ per month.

But essentially the Social Security Administration will keep giving you $3 to buy that gallon of milk for a year. Then they will start paying you $13.35 to buy that gallon of milk, but the price will move up to 445% x $13.35 = $59.41 during the second year of 445% hyperinflation—about $4 per month. But again, you will only get $13.35 to buy that gallon of milk for a year until the next adjustment.

So how often they adjust per year is crucial when the inflation rate goes higher.

But wait! There’s even more! A lag.

How often they make the adjustment per year is not the worst part of the too-slow problem. There is also a lag between when they look at the current prices and when they publish what those prices were.

In the case of the TIPs bonds, for example, it is a three-month lag. That is, the semi-annual adjustment they make in, say, April, will actually be for the inflation that occurred in the previous July through the January!

During Weimar Germany inflation, it hit 30,000% per month. at that rate, a “Value Meal” at McDonalds that costs $1 on January 1st costs $300 on February 1st, $90,000 on March first, and $27,000,000 on April 1st—when they adjust the principal on your TIPs bond so you can afford the “Value meal” at its January 1st cost of $1.

Thanks for nothing.

And remember that the adjustment to your principal on a TIPs bond is taxable. So on the next adjustment date, you will see your principal adjusted to $27,000,000 x 300 x 300 x 300 x 300 x 300 x 300 = $19,683,000,000,000,000,000,000—$19.683 quintillion dollars. Good luck paying the income tax on that at 40%.

So you see, inflation fans, a three-month lag can be a very big deal during hyperinflation. Indeed, you still won’t be able to buy that McDonalds “Value meal” which will cost $19,683,000,000,000,000,000,000 x 300 x 300 x 300 = ??? by the time you get the adjustment because of the next three-month lag.

Real, after-tax

What matters is the real, after-tax adjustment to the amount owed to you. “Real” means you have to adjust for inflation as of this minute—no semi-annual or lags or any of that. Also, it has to be after tax. If they only adjust you before tax, and you have to pay tax on the adjustment, you are no longer adjusted. You’re screwed.

How to deal with such cost-of-living adjustment problems during hyperinflation is one of the many issues covered by new book How to Protect your Life Savings from Hyperinflation and Deflation.

Bogleheads don’t like this article but can’t cite any errors

There was a discussion of this on the Bogleheads web site on 5/31/11. They are named after John Bogle who is one of the few people I list in my National Treasures list. Apparently Bogleheads are do not much resemble their name sake.

They did not like this article. Why? Apparently because they have been boosting cost-of-living increase clauses like those in TIPS and lack the character to admit they’re wrong when it is explained to them.

What did they say was wrong with the above article? They were unable to find any errors or omissions in my facts or logic

So what were their complaints? Here they are with the number of the pertinent intellectually-dishonest debate tactic being used in [red].

One said I had too much coffee when I wrote it. [4, 11, 25, 27, 30, I have never had any coffee in my life.]

One said, “I prefer to follow Mr. Bogle’s lead…” [4, Kind of redundant with your calling yourself a Boglehead.]

One said it was “over the top.” [11, 25, 27, 30]

Another said it was “a bit dramatic.” [11, 25, 27, 30]

Another said “this teaser did not impress me.” [3, 7, 25, 27]

Conspicuous by their absence are any complaints with even the sllightest bit of substance. I surmise from this that the Bogleheads are a mindless cult of personality.