How to Protect Your Retirement from Inflation

If you’ve paid attention to recent media headlines, you know that prices have been increasing (significantly, in some cases!) across almost every sector of the economy.

For example, Kelly Blue Book reports that new vehicle prices recently hit an all-time high and increased by an average of 12.1% from September 2020 to September 2021. During the same period, gas prices increased by almost one dollar a gallon. The federal government also recently warned that heating bills could jump by 54% compared to last winter!

While these upward price trends will continue in the short term, they will eventually slow down—although economist opinions differ as to when.

For many, a short-term inflation cycle is perhaps not a top concern. However, if you end up living on a fixed or limited budget in retirement (like most of us), inflation becomes much more significant. Compounded with the fact that we’re living longer and spending more time as retirees, it becomes increasingly likely we’ll be exposed to several inflationary cycles in the years to come.

You'll therefore need to address inflation in your retirement plan to maintain your retirement goals against the backdrop of this challenging landscape. In this post, we’ll show you how!

An overview of inflation

Inflation is a decrease in purchasing power—meaning you can buy fewer goods and services for the same amount of money.

For example, as inflation has averaged approximately 1.76% over the last five years, a $2,000 item you purchased five years ago would now cost $2,156.70 (in practical terms).

Inflation isn’t always bad, however; growing economies typically have modest inflation rates. The real danger, though, lies in the possibility that your income will stay the same amidst these rising prices: which can create sharp consequences, primarily for those who live on a fixed or limited budget.

How inflation can impact your retirement

In addition to the cost of daily purchases, inflation can adversely impact retirement in many other ways. Here are some of the most significant ways.

Social Security benefits
The Social Security Administration (SSA) is required by law to prevent inflation from eroding the purchasing power of benefits paid to recipients. They do this via a cost-of-living adjustment (COLA) based on the Consumer Price Index (CPI-W), which tracks retail prices and their effect on urban hourly wage earners and clerical workers. The SSA announces this cost-of-living adjustment every October and states that in 2022, the increase would be 5.9%.

One way to think of COLA is like a raise in your paycheck. Although the "raise" only covers the cost of inflation, you'll often see a yearly boost in your benefits.

COLA may sound great on paper, but, in actuality, the purchasing power of Social Security has eroded over time. According to the Senior Citizens League—one of the nation’s largest nonpartisan groups for seniors—Social Security benefits have lost 33% of their buying power since 2000. How could that be, you ask? The CPI-W under-weights specific sectors that have experienced very steep prices. Examples include the price of prescription drugs, homeowners’ insurance and property taxes, Medicare premiums, and fresh fruits and vegetables.

Healthcare expenses
Medical care inflation has consistently risen much higher than the overall inflation rate over the previous decades. In fact, since 1947, this sector has experienced an average annual inflation rate of 5.12% (per the U.S. Bureau of Labor Statistics). In comparison, the overall inflation rate during this same time period averaged 3.41%. This trend is primed to continue, as the Henry J. Kaiser Family Foundation estimates per capita spending is expected to grow at an annual rate of 4.6% through 2028. Meanwhile, according to the Congressional Budget Office (CBO), inflation will hover at slightly over 2% until 2030.

So, what exactly does all of this mean? Inflation pushes healthcare costs into even higher territory. According to Fidelity, a healthy male-female couple retiring in 2020 can expect to spend almost $300,000 on healthcare in retirement!

Savings & investments
Let’s assume you plan on retiring in twenty years and that you’re saving $500 per month ($120,000 total) and earning an average annual return of 7%—a number more in line with historical trends. In this scenario, you’d end up with $261,982.70. Assuming a 2.5% inflation rate, the future value of your $261,982 rings in at $159,880: meaning you won’t be able to buy as many goods and services as you might think.

How to plan for inflation in retirement

You can manage inflation risk during retirement in various ways. While individual situations naturally vary from person to person, here are some common ways planning strategies:

Manage your costs during retirement
According to the latest Consumer Expenditure Survey, the average retiree household spends $48,872 annually. The biggest expense? Housing, which includes mortgage, rent, property taxes, insurance, maintenance, and repair costs and represents over 35% of annual expenditures for retirees. Paying off your mortgage and building equity before retirement is an excellent first step: giving you more breathing room with respect to spending, especially on necessary items adversely impacted by inflation.

Optimize Social Security benefits
The age at which you decide to collect Social Security will determine your monthly benefit amount. Choosing to receive benefits before reaching full retirement age (the age at which you’re entitled to 100% of your benefits) means you’ll see a permanent reduction in your monthly benefit.

More specifically, Social Security benefits increase by approximately 7% each year between age 62 and your full retirement age. This increase then rises to around 8% each year between your full retirement age and age 70, meaning it may make sense to keep working or rely on other retirement income sources until you blow out the candles on your 70th birthday.

Develop a retirement income strategy
Here, you’ll need to think through your sources of income during retirement and create predictable income streams with what you have. Though this may add risk, it may make sense to maintain a decent allocation in stocks to help you keep up with inflation since, historically, equities have higher returns. Additional investments to consider are Treasury inflation-protected securities (TIPS) and annuities indexed per the inflation rate.

In sum: inflation & retirement

Inflation is just one of many potential risks you'll need to prepare for in retirement. However, since this phenomenon is a surefire occurrence, you’ll need to plan for it, accordingly. Consulting with a financial professional offers a great way to start.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific financial or tax advice or recommendations for any individual or business.