Just how – and how badly – can inflation spoil a comfortable retirement? The answer is a little cloudy.
Like sunshine to Dracula, inflation can eat away at retirement savings until nothing is left. But that’s something you likely never thought you’d have to worry about, regardless of whether you’re near the end of your career or just starting out, because inflation has been relatively low for decades.
Well, think again. In 2022, inflation reached 40-year highs topping 9%.1 While it’s since been on a glide path to around 6.6% this year, that’s still well above pre-pandemic norms.2 There’s no guarantee about what will happen next month, next year, and especially not when you’re ready to begin your retirement.
Just how – and how badly – can inflation spoil a comfortable retirement? While the Consumer Price Index (CPI) gets most of the attention, your personal inflation rate may vary significantly from the CPI. That’s because the basket of goods that goes into the CPI may not reflect how you spend your money.
Food, energy, and transportation are significant drivers of inflation, but relatively small parts of the typical retiree’s budget. The families and homes of retirees are smaller, and they’re not commuting daily to work. On the other hand, retirees spend more than the CPI average on inflationary expenses such as healthcare and services. Where you live can also influence the amount of inflation you experience – something you might consider before settling on a retirement community.
All this matters because inflation raises the cost of things the retiree wants to buy, without similarly raising the fixed income that is often at the core of the retiree’s retirement fund. A planned $50,000 annual budget may eventually require, say, $80,000 – with no way to make up the $30,000 difference except by eating into retirement capital. And that can raise the specter of outliving one’s money, a frequent worry for retirees. That’s half of a painful one-two punch. The other: When the government raises interest rates to fight inflation, it can devalue the retiree’s fixed-income investments.
Many retirees depend on Social Security for a good chunk of their retirement income, and there’s good news there: Social Security has a Cost of Living Adjustment (COLA) to help compensate for inflation. For 2023, that COLA increase will be 8.7%, higher than the 6.6% inflation we may see this year.3 That means an increase in real, inflation-adjusted dollars for retirees. Retirees can use additional money, especially after last year, when the COLA increase of 5.9% was not enough to compensate for the 9.1% inflation.4 Looking ahead, another storm cloud looms on the horizon: with Social Security at risk of insolvency, its formulas and payouts may be revised downward, meaning less retirement income for you.5 Thankfully, there are some things you can do to help.
Plan for inflation.
That’s easily said but not easily done. Someone who retired over the past few decades only needed to consider a fairly low annual inflation rate. Will inflation drift back to that level? Stay at its current level? Settle somewhere in between? Together with your financial professional, you can work up models that show you the income you need for the circumstances you envision. You can be conservative, and anticipate higher-than average rates, or you can roll the dice and plan for lower rates. But prepare yourself: if rates don’t drop as you anticipate, it may require you to curtail some spending or find a part-time job.
Diversify your portfolio.
Diversification could help you manage risk, including inflation. Together with your financial professional you may consider investments with historical returns that have outpaced inflation. Highly conservative investments tend to be more predictable but are also less likely to deliver the returns you may need. While past performance can't be relied upon to produce the same future results, it generally makes sense to utilize a well diversified portfolio.
Watch your “buckets”.
Some retirees use a “three bucket” system in which the money you’ll need soonest is put in a relatively safe, conservative bucket; money you’ll need over the next ten years is put in a somewhat riskier, higher return bucket; and money you won’t need for another ten to twenty years or more is put in a still-riskier bucket that that could help your money outpace inflation, and give you time to recover if they don’t. You might be tempted to put more of your money into the conservative bucket during inflationary times – but it may be wise to consider balancing that against the need to grow your investments for your later years.
Keep an eye on your investment fees.
They can be an added cost that nips at the value of your investments when you’re trying to preserve and grow your capital. This is a particular issue for people who consolidate several low-fee 401 (k)s into a single IRA that may have higher fees.
Get the most from Social Security.
Literally. It’s generally a good idea to wait until you achieve full retirement age (between 66 and 67, depending on when you were born), or even to age 70, to get a larger monthly benefit. But there’s an inflation edge at work here, too. Because the COLA is figured as a percentage, the higher your current benefit in dollars, the larger your increases will be.
Inflation adds another layer of complexity to retirement planning. Your financial professional can help you navigate it.