My top-recommended retirement book is How Much Money Do I Need to Retire?. It’s written by my friend, Todd Tresidder, who blogs at Financial Mentor, and it’s simply excellent!
In fact, it’s good enough to make my list of the only five money books anyone needs to read as well as be one of the 12 books that can make you a financial expert in a year.
The book was fabulous the way it’s been for years, but Todd recently updated it plus added additional content. The new version is now available for sale.
I thought that we’d celebrate the update by running an except so you can see the book for yourself.
Todd let me select what portion I wanted to post and I selected this one on inflation and why it’s the biggest retirement threat.
I picked it because the topic doesn’t get that much coverage from the mainstream media and blogs (including mine), and yet it’s a vital issue that needs to be considered and planned for.
This is especially true for early retirees. For those who retire at a more-traditional 65+, the inflation issue still exists but isn’t that profound. But when you retire and still have 30 to 40 years of life left, planning for inflation is a HUGE issue that must be addressed.
And there’s no one better to cover it than Todd. His highly analytical, get-to-the-point, no-nonsense style is perfect to get us thinking about the key issues surrounding this topic.
So with that said, here’s Todd…
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“I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around (the banks) will deprive the people of all property until their children wake up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.” – Thomas Jefferson, 3rd US president and Founding Father
Inflation is an insidious cancer that consumes the purchasing power of your wealth over time.
When my grandmother retired, she could have bought a new Ford Mustang for about $2,700. By the time she passed, a comparable new Ford Mustang cost more than $30,000.
Inflation is a reliable problem because it’s intentionally created by government policy. Since the advent of the Federal Reserve, the government has destroyed the purchasing power of the dollar by almost 90 percent…twice!
Traditional retirement planning typically assumes a 3 percent inflation rate. At that rate, the amount of money you need to spend to maintain your current standard of living roughly doubles every 24 years. In other words, if you spend $100,000 per year right now, then you should expect to spend $200,000 per year in 24 years to support the same lifestyle. Since most people can expect to live 24 years (or longer) in retirement, this obviously is an important issue.
But where did that 3 percent assumption come from, and can you rely on it for your retirement plan? Like most everything else in retirement planning, the answer isn’t as straightforward as it seems.
The 3 percent assumption is based on historical evidence. Since the late 1980s, inflation has been relatively mild, averaging 3 percent or lower. In addition, very long-term history has averaged similar.
However, during the 1970s and 1980s, inflation spent more than a decade in the 5-10 percent range. A decade is a long time. It has also spiked to the 20 percent level during wars and oil shocks, and it has been negative for isolated periods during recessions. In short, the 3 percent inflation assumption is based on such a broad interpretation of history that it overlooks details that could significantly impact your retirement plan.
What matters is the inflation you can expect in the future, not the past. And nobody knows with any confidence what future inflation will be because the past is not necessarily indicative of the future. Knowing the next 15 years of inflation would require either a crystal ball or a direct connection to a higher power. I don’t have either and neither does your financial planner.
What we do know is the rate of inflation fluctuates, so it’s not realistic to simply extrapolate the recent past forward, as is common practice. This is important because a small change in the inflation assumption will make a dramatic difference in the amount of savings required to retire.
The Single Biggest Threat to Your Retirement Security – Revealed!
For example, a 6 percent inflation rate means your income requirements roughly double every 12 years. At a 6 percent inflation rate, a 65-year-old spending $100,000 per year today will be spending $400,000 per year at age 89 and $800,000 per year if he lives to 101. That is significant, to put it mildly. In fact, inflation is probably the single biggest threat to financial security that retirees face. It’s a really big deal.
Unfortunately, the importance of this threat is not intuitive to most people because small 1 to 2 percent changes in the annual inflation rate compound into unexpectedly large differences in purchasing power over time. Worse yet, to fully understand the impact of inflation, you have to net out its effect on both your purchasing power and your portfolio growth at the same time, which few people do.
In other words, you first have to look at how much your investments grow and then subtract the loss of purchasing power due to inflation over the same time to determine if you gained or lost net value. This is important, and eye-opening, because both stock and bond markets tend to underperform during periods of rising inflation. Your investment portfolio grows less than expected at the very time that your purchasing power for those same assets declines faster than expected. The net effect of both can be devastating to your retirement plan.
To illustrate how this works in practice, let’s look at a few time periods using inflation statistics based on the US Consumer Price Index. We’ll relate them to stock market performance using the S&P 500 Index as measured by Professor Robert Shiller’s data from Yale University.
- An item purchased for $100 in 1965 would cost $234 in 1980 (just 15 years later). That is 5.83 percent average annual inflation for a total inflation rate over the entire period of 133.95 percent.
- Using the same time period (January 1965 to January 1980), the total S&P 500 return without dividends was a mere 28.77 percent (or 1.7 percent annualized growth). With dividends reinvested, it was 125.1 percent (or 5.56 percent annualized).
- That means this popular stock index actually gained less over the 15-year period than that same portfolio lost in purchasing power due to the erosive effects of inflation. (Note: The majority of investor portfolios perform worse than this index.) In other words, you were a net loser after 15 years of investment performance that more than doubled your portfolio, simply because of inflation.
- In fact, if you adjust the S&P’s performance for inflation, the index return lost a total of 48.36 percent in purchasing power over the 15 years. The total return, including dividends reinvested, lost 9.73 percent (net of inflation). Yes, you read that right. Your investments doubled, but you lost purchasing power because of inflation. That’s a serious problem if you’re retired and trying to live off your assets.
- Maybe you’d argue that the time period was too narrow or I was handpicking a brief period of high US inflation. Not a problem, because according to Charles Ellis in Winning The Loser’s Game: Timeless Strategies for Successful Investing, the 1993 Dow Jones Industrial Average was equal to its inflation-adjusted level in 1928. That means investors endured a full 65 years with no gain net of inflation.
Inflation is the single biggest threat to your retirement because it can’t be accurately estimated, you have no control over its occurrence, and the effect compounds over time, magnifying small errors into big problems. It works like a savings account in reverse, compounding in the wrong direction, so that a mere 2 percent change in your inflation assumption could single-handedly double the amount of money you need to save for retirement. That’s a life-changing difference.
Your Personal Inflation Rate Might Be Different
Before you throw in the towel, thinking that inflation will eat you alive in retirement, it is important to note that not everyone experiences inflation the same way. Your spending patterns and where you live could mean you experience a totally different rate of inflation than national statistics.
Even the Bureau of Labor Statistics recognizes that senior citizen spending is different than the average consumer, so they created a special index called the CPI-E (for Elderly) which varies the weighting of the various components to better reflect retiree spending patterns. It reduces the weight for items like food, beverages, and transportation while increasing the weight for medical care.
In other words, the senior citizen “basket of goods” contains a lot less food than a family with hungry teenagers, but the seniors also spend more time getting medical care. This means an increase in medical costs will more dramatically impact their overall spending versus an increase in the cost of milk, bread, and eggs.
The same can be said for where you live. A 2 percent increase in the cost of housing is likely to have a much bigger impact on someone in New York City or San Francisco than in Kansas City or Buffalo.
Darrow Kirkpatrick, author of Can I Retire Yet, has tracked nearly every dollar he’s spent since 1989. His personal inflation rate doesn’t mirror government data—it’s not even close. He’s found a few expenses are higher, many are roughly the same, and some are lower. Overall, his spending has not risen as indicated by general consumer inflation data.
This leaves you with a wide range of choices for choosing an inflation rate when calculating how much money you need to retire:
- At one extreme, you could assume future inflation will be higher than long-term history would indicate because the financial future of the country is uncertain.
- The middle road would be to assume long-term historical inflation rates figuring you have a little leeway, since senior spending should be less compared to the average consumer.
- Finally, the opposite extreme would be to assume low inflation because you’re in control of your spending, so you can manage your personal level of inflation through spending choices.
The best approach is to stress test your savings requirements by using a variety of expected inflation rates rather than picking a single number. The only thing you know for sure about future inflation rates is that you don’t know. And the one thing you know for sure about retirement planning is you don’t want to run out of money before you run out of life.
That means the prudent step when planning is to test a range of inflation assumptions so you know what inflation level your assets can support. How high you want to estimate depends on how conservative you want your calculations to be and the level of security you require in retirement. Declaring any number for inflation 20 to 30 years into the future is only a guess. There are simply too many unknowns and variables. But that doesn’t mean all is lost.
Reduce the Impact of Inflation Risk
Even if your estimate is wrong, the problem can be contained to a manageable level by iterating your plan, including your inflation assumption, by recalculating your number every few years. That way, you replace assumed data with actual experience.
You’ll revisit your retirement calculation every few years to check your assumptions and see what you’ve spent. If your estimate for inflation is wrong, it’s not wrong for long. You’ll know for certain if your spending is rising faster or slower than your inflation estimate, and you’ll know if your portfolio is performing better or worse than your investment return estimate. In other words, you reduce risk by replacing assumptions with actual data.
Each time you update your plan, you have an opportunity to adjust your lifestyle or other assumptions in the plan to balance everything and make the numbers work.
And if you don’t really like this approach to making the traditional model work, then I have another planning model to help you. It’s simpler, more robust, and completely tames the inflation monster without requiring any assumptions at all. But for this phase of the analysis, we need to work with an inflation estimate. Pick a range for inflation with which you’re comfortable between 2 and 8 percent (e.g. 2 to 8 percent), then write the range in your exercise workbook so you’re ready to build your confidence interval when we start calculating your number.
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Good food for thought, right?
And as someone who likes to have a margin of safety (or more really) for all retirement threats, here are some thoughts on how I plan to deal with inflation (or am already dealing with it):
1. I own my house.
I own it outright. No debt. No payments. No need to move if I don’t want to.
While this doesn’t completely eliminate a housing inflation threat (there’s still insurance, taxes, etc.), it does help to minimize it in what is generally a very high-cost budget item for most people (which means it can impact your personal inflation rate more).
2. I could move.
I live in Colorado Springs, not the most expensive market in the world but not the cheapest either. Best Places lists it as almost 13% more expensive that the U.S. average including a whopping 45.5% higher on housing cost than the U.S. average.
So if things got dicey, I could move to a much lower cost of living city or even back to my hometown in Iowa. This would save me tons on all sorts of costs, including housing.
3. I could downsize.
We don’t need a 3,500 square foot house any longer, so as I was moving to a lower cost of living city we could go for a more reasonable 1,500 square foot house, making things even more affordable.
4. We could cut spending dramatically.
As evidenced in How to Become Financially Independent in Five Years, we could massively lower our expenses if we had to.
5. Real estate helps.
If inflation does raise its ugly head, it’s likely that monthly rents will increase as well. That means my rental units will become more profitable and help dampen the impact of rising inflation.
6. We could move into one of our rental units.
We have 14 units at the current moment, so if worse came to worse, we could sell our home and move into one of the rental places. They are in Grand Rapids, Michigan, a generally affordable city, so that helps too.
7. We could re-deploy assets.
If inflation kicked in there could be a corresponding (at least partially) increase in returns for some asset classes. We could move assets from where we have them now (like our big pile of cash) to options that would perform better, again limiting inflation’s impact on us.
Anyway, those are my thoughts. What’s your take on inflation in retirement and how are you planning for it?
Xrayvsn says
I am creating a portfolio along the same lines to help counter inflation.
I do think real estate is the best bet to do so as inflation will be counterbalanced by increasing rent. I too have a fully paid off home to make sure my housing costs can be relatively fixed.
Another less talked about risk is deflation which can also create havoc for a retiree.
WRHWRH says
Does anyone think adding TIPS to your portfolio is an effective way to hedge against inflation. If so, what percentage of your portfolio should be placed there?
Apex says
Zero. Due to extremely low interest and extremely low inflation TIPS pay next to nothing.
The best guaranteed hedge against retirement inflation is not taking social security until age 70. It has a guaranteed 8% annual return for each year that you delay taking it and then that amount is adjust for inflation every year for the rest of your life. That is far better than TIPS.
Inflation isn’t going to soar through the roof overnight. Furthermore we have had a vigilant fed on inflation for 40 years. As much as people love to point to the fed as a risk to inflation the fed has proven to be a great backstop against inflation. The fed has precipitated multiple recessions over the years to stay ahead of inflation. Until I see evidence that has change I have great faith in the fed to keep inflation under control in the USA.
And the last 10 years have been the greatest evidence of this. I know of almost no talking head, expert, investor, etc, who hasn’t said since 2009 that the fed was fanning inflation and it would soon be here and start to run. They have all be very wrong. The fed started to get a little concerned about inflation in 2018 and raised rates 4 times. By Christmas of 2018 the stock market had collapsed 20% and the economy was looking weaker. The fed tried to get in front on inflation. They were vigilant. Too vigilant. They had to reverse course with three rate cuts in 2019. Once again the talking heads began to warn about the fed letting inflation run. They pull out the same story every time the fed cuts rates . They were wrong in 2009 … 2017. They were wrong again in 2019 … Someday they may be right, but when you have warned incorrectly for so long, being right is nothing but pure chance.
Have hard assets like real estate and stocks and you are mostly protected against inflation. Nothing is certain but that’s as good as it gets.
Mike Hernandez says
I think you may be overlooking a benefit of leverage on real estate in inflationary markets. If 30 year debt is locked in on real estate, then each year of inflation the relative cost of that debt will go down. Using your example, in 24 years the debt servicing payments are worth roughly half as much. In the meantime, your rents have doubled and the property value has probably also doubled if they are following the same inflationary trends. The same can also be said about long term debt on your personal property, without the rent effect of course. However, care should be taken because over leverage can quickly put you underwater in a steep market decline as we have witnessed just 10 years ago. Everyone needs to adjust for their own risk tolerance.
Apex says
This is exactly right Mike.
There is nothing leverage loves more than inflation. And there is no better way to benefit from inflation than leverage (Not simply debt, leverage. There is a big difference)
Alas for those who are appropriately levered, especially in real estate, inflation has been tame, tame, excessively tame.
And I do mean excessively. Inflation has been below 2% for over a decade and below zero for part of that time period. Luckily the fed stepped in and lowered interest to zero, quadrupled the balance sheet to $4 Trillion through quantitative easying and used electronic money printing to try to kill deflation. They stopped deflation but have still not truly been successful at re-inflating the economy. That’s why they had to lower interest again in 2019 after thinking they could focus on inflation in 2018. They had stopped deflation but had not yet created any inflation and raising interest rates threatened to return us to deflation which they finally realized. There seems to be something about the current global economy that mostly puts a huge lid on inflation across the globe. (Backwards third world banana republics / Marxist tyrannies like Venezuela excepted). This excessively low inflation environment may seem good, but when inflation is too low the results are stagnation. Zero inflation or deflation destroys economies. See Japan circa 1989 – present.
Mike H says
I like Todd Tresider and signed up for some individual coaching sessions with him. During these sessions, Todd’s own plan for mitigating a weakening USD and inflation was to purchase a basket of different stocks at a good valuation and let the dividend raises provided by the companies offset the loss of purchasing power from inflation.
I studied more and deployed that strategy back in 2014 and it has worked very well. I’ve seen that even if I’m spending the majority of dividends will little to no reinvestment that the payouts should average 5% growth per year or slightly above inflation.
Because I’ve been reinvesting dividends and adding fresh cash along the way the growth per year for the past 5 years has been more like 20%. That builds up a margin of safety pretty quickly.
-Mike
Vano says
It depends what you are trying to protect against. Stocks thrive in low and falling inflation environments, and can still deliver positive real returns in periods of moderate inflation, but when it starts to spiral higher then a dividend payout isn’t going to insulate you from the beating that all stocks will suffer. Stocks do not exhibit “hedging” characteristics, merely inflation-beating characteristics that can deliver positive real returns so long as the inflation doesn’t run too high. I like dividend stocks as I consider them more defensive play than growth stocks, but I still think that ultimately they’re risk-on assets that will get crushed in an inflationary environment that is more hostile to economic expansion.
Dean Erlandson says
One way we are hedging against future inflation is planning to take only 1.5% a year from our retirement plans. In good years with low inflation our plans should grow in net value while reducing the impact from withdrawals in poor economic years. We also agree that real estate is a good hedge given market values and rents tend to rise with inflation as long as you stay away from speculative real estate market areas.
Diogenes says
Well that was depressing, and scary, but necessary and much appreciated information. Thank you! Regarding inflation and investing, I found this article very interesting. Not sharing this for political purposes, but for financial and informational purposes only:
“Paul Volcker, the Fed chairman at the time, knew that this had to stop. He took extraordinary measures to stop inflation, pushing interest rates to historic highs. By 1981, he had driven the prime rate to 20%. The high-interest rates caused a genuinely horrific recession. The recession of the early 1980s was slightly worse than the Great Recession of recent memory. Unemployment peaked at 10.8% in 1982. In comparison, it peaked at 10% in 2009.
Ronald Reagan, to his credit, stuck by Volcker’s tough medicine even though it was not in his political interest. Reagan’s poll numbers dropped into the 30s. A lesser President would have fired Volcker or publicly criticized his actions. Reagan did no such thing. He knew that inflation had to be contained and knew it was in the long-term interests of the country to beat it.
The tough medicine worked. Inflation was defeated. As inflation eased, we were able to reduce interest rates for nearly 40 years. The bond bull market has benefited almost every U.S. asset class for the last few decades. We have been reaping the benefits of Paul Volcker and Ronald Reagan’s tough medicine for decades.”
https://valuestockgeek.com/2018/07/20/are-bonds-for-losers/
PWilliam says
You should probably add Jimmy Carter to this list too. Carter’s presidency like Nixon’s and Ford’s before him was dogged by inflation. Carter appointed Volcker with the understanding that he would fight inflation. He did, pushing short term interest rates way up, for which Carter took a pounding, and as you point out, Reagan did as well for his first couple of years.
Diogenes says
Jimmy who? LOL…nah, seriously, thanks for sharing that, PWilliam! I couldn’t possibly have added that because I didn’t know, and it’s not mentioned in the linked article. I’m still learning American history, whatever I can read whenever I sneak into the new library in Alexandria, and/or borrow a scroll or two to read inside my old, leaky barrel.
Good for Carter for appointing Volcker. That actually makes it even more admirable that Reagan didn’t fire Volcker or publicly criticize his actions, since Reagan didn’t appoint him.
JayCeezy says
“When my grandmother retired, she could have bought a new Ford Mustang for about $2,700. By the time she passed, a comparable new Ford Mustang cost more than $30,000.”
True. If that same Mustang was garaged, it would sell today for >20x. And, it would last 50% longer. The house she bought that year would sell for >25x. (My folks bought a house in 1966 for $11,000 and it is listed today for $1.4 million with no structural changes) I do take Tressider’s point, while recognizing that Baby Boomers especially have benefitted from high inflation. Social Security payments are indexed to U.S. payroll wage increases (much higher than inflation), and not the much lower inflation rate.
Household blended tax rates have declined overall, over those decades. ESI makes the accurate point that taxes might be the largest expense for a high-NW household. But for half the country, nah they pay pretty close to zero (trollbait, but true). Taxes go WAY down in retirement (more trollbait, also true) My eye is on Deflation. Productivity increases and Demand decreases are real, and happening. We’ll see…
Apex says
Cherry picker.
Double cherry picker!
* 1965-1980 period was the beginning and ending of the most dour stock market in modern history. Stocks spent 16 years going absolutely no where with a slight downward tilt that whole period. He picked the beginning and ending years almost exactly. Cleverly misleading.
* 1928-1993 was the year before the worst stock market crash in history and right after the roaring 20s and the largest decade of excessive stock market returns in history. Choose 1933 – 1993 and the story will show AMAZING returns.
He knows he will be called out for cherry picking so he gives a second example and this time using a time period that someone else used in a book. Unfortunately that example is an even more carefully constructed cherry picked time period and just because someone else used it in a book doesn’t make it any less cherry picked. Why do you think the author of that book picked that period? Because it told the story he wanted told. It was a carefully constructed cherry pick.
Date ranges are often cherry picked to tell the story the author wants told. Its a very disappointing use of “data.” The point about inflation is not invalid. However, the cherry picking is simply a lazy way out that serves to exaggerate the point without having to do the hard work of showing what happens most of the rest of the time. But it is often quite effective to those who aren’t privy to the details that make the cherry picking so obvious.
Geme says
As an economist, i totally understand your point. But I also support the need to twist data to attract the attention of regular ppl. The general public need rude wakeup, i think.
Best
M169 says
My first professional job after graduating from college was in 1980. The first raise I got was 16%, mostly due to high inflation. Many people at that time were buying consumer items as soon as they could, knowing that next year the prices will go up substantially.
At retirement I took most of my pension in a lump sum and invested it in a stock index fund as a hedge against inflation, since the annuity payments were not adjusted for COLA. I also own my house, which fixes majority of housing costs. The rest of my investments are mostly in equity ETFs, which historically beat inflation (perhaps except for the cherry picked dates in the book).
I also plan to delay taking Social Security until age 70, since it will grow substantially before then and is adjusted for inflation.
The Wealthy Weasle says
Well, this is quite misleading:
“When my grandmother retired, she could have bought a new Ford Mustang for about $2,700. By the time she passed, a comparable new Ford Mustang cost more than $30,000.”
Yes a car called a Ford Mustang will list out at $30k, but is it comparable?
The vintage ‘stang likely had drum brakes, (not discs with full ABS) carbueration (not fuel injection), no air bags, miserable radio (not a 10 speaker luxury sound system), sticky vinyl seats, (not leather), probably less than half the horse power, x times more pollution, an engine life expectancy below 100,000 miles (not the 200,000+ that you regularly see on these things, today), no driver assist, no lane monitoring, no skid control, and likely about half the fuel economy.
To get something remotely comparable to a basic ’60 s Mustang, you might buy a stripped down Crown Vic that has about 100k police cruiser miles on it. It would still have many features that the Mustang would not, get better mileage, have more power, and probably last longer. You can find these around regularly at auction for $3-5k.
Of course, buying a new car is a choice, but it is not the only choice, nor really even close to comparable in this example. The comparison serves to dramatize “the problem,” so we will pay more attention to the solutions.
Steveark says
Some numbers I take comfort in. Inflation historical average is 3.1%. S and P 500 average annual increase is 9.8%. I can’t get too worried knowing that. Sure inflation is a thing. I lived through the Jimmy Carter double digit inflation years. But guess what, I got 30% annual raises and had10% cd rates. It was pretty good times. Venezuela level inflation would be bad, but it isn’t likely here. Good points, but I think it is on the low end of things to worry about. Of course I’m wrong a lot.
Robert King says
We decided to approach the inflation issue by purchasing rental real estate for cash. We now have 30 paid-for rentals and they are spread across the country for diversification generating $25K monthly. Additional diversification is investing in hard money loans at 10% interest, generating alone more income than when we were working. We have less than $1,000 in the stock market. Even if real estate tumbles, rents have remained steady.
Vano says
Commodites are the asset class that thrive in periods of high inflation (far more so than real estate). They are completely overlooked right now because nobody anticipates a return to higher inflation, but this is why you should have exposure to at least some if you want to hedge your portfolio. It’s cheap to do so – the CRB/Dow ratio has never been lower.
Papa Foxtrot says
Some believe hyperinflation may occur again. Truth is for hyperinflation to happen, most people have to lose faith in the economic system entirely. If that is going to happen, your retirement fund is hardly going to exist much less matter. My mentor told me if the system falls apart, the [cans in your pantry] will matter more than the numbers in your account.
SL says
New to the blog, but really liked this article because I have thought the same thing for some time – Inflation is the biggest threat to financial security in retirement because there is no way to control for it. But after thinking about for some time, I’m now questioning if that is really the case. For example, my late grandparents (who were life-long savers) viewed the late ’70s early ’80s high inflationary environment as a windfall even though they were retired at that time. Why? Because they were getting double-digit returns on CDs. Now we all know they were wrong about that (at least I used to think) because inflation eat up those returns and then some. Right? Well, yes in theory, but perhaps not in practice. They owned their home out right and their lives consisted of gardening and going to the grocery store a couple times a week. Sure, their grocery bill and utilities went up, but not nearly as much as the returns on their savings. Coming back to the article, we can control our spending, and spending increases do not necessarily equivocate to the inflation rate, and particularly not in retirement. I disagree with the part of the article that you need to both increase your spending rate and discount your return rates for inflation. My thoughts are that you only adjust your spending rate for inflation. Inflation will generally increase your return on investment (with the exception of long-term bonds, which I personally see no reason to be invested in in this environment). Kudos to the writer for a great article and I look forward to reading more.