Personal Finance: Diversifying Portfolio Can Help You after the Divorce
Inflation works like an insidious, regressive tax whose impact is often not factored into divorce agreements. It can be either your friend or foe depending on whether you are making or receiving spousal or child support payments.
To illustrate the point, let’s assume Linda and Jack have been married for 30 years and their divorce decree states that Jack must pay Linda $3,000 per month for the rest of his/her life, an estimated thirty years. The value of that payment in 30 years will be only $1,236 per month in today’s money, assuming a 3 percent inflation rate. So while Jack benefits when inflation rises, Linda suffers because her alimony check won’t buy her even half of what it did when her payment was awarded. The following table shows the value of Jack’s payment to Linda over time depending on the rate of inflation.
| Inflation | 10yrs | 20yrs | 30yrs | 40yrs |
| 0% | $3,000 | $3,000 | $3,000 | $3,000 |
| 3% | $2,232 | $1,661 | $1,236 | $920 |
| 5% | $1,842 | $1,131 | $694 | $426 |
| 10% | $ | $ | $172 | $66 |
How is inflation measured and does it accurately reflect the increase in our cost of living?
The most widely used measure of inflation is the Consumer Price Index (CPI), calculated by the Department of Labor (www.bls.gov/cpi/). This index tracks the price change from month to month of a basket of goods and services used by the average consumer. CPI components include; food and beverages, apparel, housing, transportation, medical care, education and communication, and other goods and services. The average inflation rate as measured by the CPI has been roughly 3 percent since 1914 and just under this rate over the last five years.Keep in mind that the CPI measures prices in urban areas only so the costs of maintaining a suburban home and commuting a long distance may not be fully captured in this number.
So how can you protect yourself against the impact of inflation?
1. In some states, maintenance awards have an escalation clause.
An escalation clause is a cost-of-living provision in a separation agreement that ties an automatic periodic rate of increase for spousal or child support payments to the current inflation rate or some other designated index. Even if your state doesn’t have this provision, you and your spouse are still free to make your own agreement on the issue. Check with your legal counsel.
2. Another way for a recipient of alimony to try to combat the effects of inflation is to invest some of the payments.
If possible, try to set aside a bit of your check every month to grow for the long term. A portfolio that earns 3 percent when inflation is 4 percent actually loses purchasing power each year. Though past performance is no guarantee of future results, stocks historically have provided higher long-term total returns than cash equivalents or bonds. Since 1926, the stock market as measured by the S&P 500 has gone up by approximately 10 percent per year on average. During this same time period, bonds have barely kept pace with inflation and cash equivalents (such as savings accounts and money market accounts) have produced a negative return when inflation and taxes are factored in.
3. Consider diversifying your portfolio.
Even though diversification does not guarantee a profit or ensure against loss, studies have shown that over the long term, a diversified portfolio with investments in a broad range of stocks, bonds, and cash equivalents has outperformed ones with only a single asset class.
