Why Does Inflation Matter?Inflation matters because you can buy less than you could before with the same amount of money. Think of how important this is! You think you’ll have a certain amount of money based on retirement planning, and you will. Only it won’t buy anywhere near as much as it did when you were planning for retirement years earlier. And like aging, you don’t see the depletion of your money from one day to the next, but you sure see it over a few years. Let’s use an analogy we can all relate to. Imagine you have a grocery budget of $ 200 a week that allows you to easily buy everything you want. You take an envelope to the grocery store with 2 crisp $100 bills in it every week. (I love crisp one hundreds!) Then time travel five years. You take that same $200 to the grocery store. Only now, you can only buy 90% of what you could buy just 5 years prior due to inflation based on the recent historical rate of inflation of 2%. (Using older data, it’s even higher than 2%!) Bear with me through one more recent example. Recently, my son grabbed a large package of toilet paper at the grocery store for me. That large package of toilet paper costs $30! It seems like only a few years ago that same toilet paper cost $12. That’s inflation! Inflation matters all right: It matters because it depletes the value of your money.
How Inflation Will Affect Your RetirementInflation is especially important in retirement planning for several reasons.
Inflation Salary IncreasesWhen you are employed and receiving an annual salary increase for inflation, which is common, it’s all good. (I remember those annual inflation increases with love and affection.) But after you retire, those COL (cost of living or inflation) salary increases are done.
Retirement Income and InflationIf you’re invested in bonds, like many retirees, the income from those bonds is fixed. The income from most bonds is not adjusted for inflation, so the bond income buys less than it did when you bought it. This applies to intermediate to long term bonds. Read my related post What Are the Risks of Bonds?
Real ReturnHere’s the real kicker, no pun intended: If income from a bond is fixed at 4% and inflation is 3% that year, your real return is only 1%. If you pay taxes or some type of wealth management fees, you could have a negative income from those bonds!
How Inflation Affects StocksMany retirees also count on stock dividend income in retirement. Since the cost of goods and services increases during inflation, some companies will be able to increase dividends to keep up with inflation. But many companies cannot raise their dividends with inflation since they will be paying more for the goods and services which are required to produce the goods they sell. Companies will also be forced to pay more for the goods and services that they need to run their business (like toilet paper and staff!). Of course, they can increase their prices with inflation, but sales can slow if they try to pass the higher costs off to their customers. Fortunately, depending on the industry, some companies are less affected by inflation, and some can even benefit from it. My video below has more that will help account for inflation in retirement planning.
Does Social Security Increase with Inflation?The good news for retirees is that social security increases for inflation. This is commonly called COLA, or Cost of Living Adjustment.
Average Inflation RateNow that you see how inflation can make or break your financial future, let’s look at my favorite investing tools, facts and history, to see how to plan for inflation in retirement. We know that the cost of goods and services rise by 3% based on long term history, and 2% in more recent years. But averages are just that. As you can see from the table below, inflation has been as high as 13.50% in my lifetime (1980) and it has also been as low as .1% in recent years. Here’s the thing to remember. Inflation is not all bad. A little inflation is good since it means the economy is growing and thriving. We just have to account for it in retirement planning, and hope it stays within the range we use to plan! And it’s hard to plan for retirement with such an large unknown factor. The chart below shows some of the most extreme deviations from the 3% historical rate of inflation.
Major Causes of InflationWhile it may seem like there’s a conspiracy to sabotage successful retirement planning, inflation actually happens for logical reasons. I have summarized the major causes of inflation below as explained further in an excellent post at EconomicsHelp.org. Basically, the causes of inflation relate to either economic growth that is too fast (demand-related) or cost (supply) related factors. (Remember high school economics?) Here are some examples of each so you understand inflation better. It’s easier to plan for anything you understand, while lack of understanding increases risk.
Fast Economic Growth/DemandHere are examples of inflation factors related to fast economic growth.
- Interest rates are cut. This happens when rates are cut to slow down the economy, so it won’t grow too fast. (Sound familiar?)
- The money supply is increased. (Also sound familiar?)
- Wages are higher. This happens when there is low employment and wages have to rise to attract employees.
Supply Related Factors/SupplyHere are some inflation factors related to supply.
- Higher wages are also a supply related factor.
- Devaluation occurs. This happens when exports rise, and imports fall.
Effects of inflationLet’s look a specific example of how inflation affects something most all of us purchase since to bring this a little more into reality. The cost of going to the movies is a great way to make inflation more real. It cost about $5 to buy a movie ticket in 2000. 20 years later it cost $9. That’s an 80% increase in just twenty years. Note that twenty years is too a short a time frame to use in planning for retirement. This can be compared to the cost of a movie ticket for someone who is 65 now and wants to go to the movie when they are 85. Based on history, the ticket cost will go from $9 to over $16! What if everything you buy costs 80% more 20 years after you retire? There is a good chance it will be based on history. You can see why it’s so important to account for inflation in retirement planning!
Retirement Calculator with InflationIt’s not all doom and gloom. Besides social security increases for inflation, more good news is that most retirement planning calculators have inflation built right into them, which makes it easy to factor inflation into retirement planning. Some retirement planning calculators have inflation of a certain percent built into the numbers. You can usually find this in the calculator footnotes. Other retirement calculators allow you to enter your own inflation rate, which can be very tricky since inflation is completely out of our control and therefore impossible to predict with 100% certainty. You can see this from the inflation rate extremes in the chart above.
How Much Inflation to Plan on in RetirementThe challenge is in knowing how much inflation to plan for in retirement. This is almost as challenging as predicting future investment returns. We know that inflation is a factor of the economy but then the Federal Reserve takes measures to control inflation. Fast-growing economies are more prone to have high inflation so the Federal Reserve manipulates interest rates to slow down the economy and avoid extreme inflation. But it is unclear whether the Federal Reserve will always be able to control inflation over the next few decades, especially in such a global economy. This is why many tactical wealth managers and smart investors add assets that do well during inflation to portfolios at various times. You can read more about such tactical portfolios in my post All Weather Portfolios Pros and Cons.
Factors That Affect Retirement SpendingRecent trends can also be a guide as to how much inflation to plan for in retirement. This can be especially valuable if your retirement is coming up within a few years or if you’re already retired.
Quantitative EasingThe first factor to affect inflation in retirement is quantitative easing. We don’t know the long term consequences of government printing so much money to stimulate the economy for years, but we do know it causes inflation. There is no historical precedent for this, which concerns me as a Boomer (sort of) retiree. For this reason, it makes sense to use a higher level of inflation in retirement planning. Better safe than sorry.
Health Care CostsThe next factor affecting retirement planning for inflation is health care costs. Rising health care costs call for a higher rate of inflation in retirement planning.
Longer Life SpansAnd finally, the longer you live, the more you need to account for inflation in retirement since inflation has a compounding effect over the years. People are living longer and longer because of medical advances.
How to Protect Against Inflation in RetirementIf inflation concerns you too, there are certain investments you can make that are inflation hedges. Common investments that help protect against inflation are TIPPS bonds, gold, commodities and real estate rentals. TIPPS, gold and commodities are easy to add to a retirement portfolio. Real estate rentals take more effort but we found them to be good long term investments. Read my post Owning a Business vs Real Estate for more.
Inflation and Retirement Planning SummaryAs with everything, the first step toward a solution is awareness. Knowing inflation is a real threat, investors can structure their portfolios in a way that will survive inflation.
The information on this website is for education only and is not to be construed as personal financial advice.