We at MoneyTips hope that you have been planning for your retirement through saving and investing wisely, and taking advantage of all the retirement programs available to you – but have you considered the effect of inflation on your retirement funds? If not, you should.
Americans have been spoiled over the last few years with relatively low inflation – so low, in fact, that some economists fear potential deflation. Inflation has been running at 2% or less (currently 1.6%), giving us one of the world’s lowest inflation rates (105th lowest), according to Trading Economics. The average US inflation rate over the last century was 3.22% and the worst post-WWII rate, over a 30-year period (representing a potential retirement span), was 5.44%.
While you may think that is not so bad, inflation is a direct erosion of your spending power, acting in the same manner as compound interest. Just to stay even with purchasing power, the rates of return on your investment must equal that of inflation. To look at it another way, a steady 2.5% inflation rate doubles the cost of goods in 28 years, 6% doubles costs in 12 years, and 8% doubles costs in 9 years.
Further, these figures are averaged across all goods and services – inflation is the not the same for all costs. According to the Bureau of Labor Statistics, for the period of 1983-2011, the inflation rate was considerably higher for health care costs (5.1% annual inflation) than for all other goods and services combined (2.8% annually).
As you age, health care becomes a disproportionate part of your expenses. The Affordable Care Act may eventually lower costs as claimed, but don’t bet your retirement on it.
Enough already, you say – you’re convinced. Now, what do you do about it? Here are some steps you can consider:
- Delay Retirement – Easy for us to say… but the fact is that you will be bringing in more income for retirement, and depending on the type of plans you have, your retirement benefits may increase.
Delay Taking Social Security Benefits – Your Social Security benefits are one of the few options that are automatically inflation-adjusted – they are currently linked to the Consumer Price Index (CPI). Not only will you increase your monthly benefits by delaying your first draw, you are also increasing the percentage of your retirement income that adjusts with inflation.
There is some risk involved, as Congress constantly threatens to alter the inflation adjustment mechanism. The most recent push is to link to the “chained CPI,” which substitutes lower cost replacement purchases and therefore lowers the adjustment level.
- Purchase Inflation Protection – Financial vehicles like annuities or long-term care insurance allow you to purchase inflation protection for a higher premium. To test if this is right for you, you would need to perform a cost-benefit analysis – how much money would you spend on extra premiums, and what level of inflation does that guard against? Online calculators can help you with this assessment.
The average inflation rate where you break even with inflation protection will vary depending on premium costs, but 4-5% is a good estimate.
- Invest in TIPS – Treasury Inflation-Protected Securities (TIPS) are bonds that adjust for inflation with changes in the CPI. The face value changes, as do the interest payments you receive. However, you cannot receive less than the original face value upon maturity. It is possible to ladder maturity dates of TIPS like CDs to keep income relatively smooth.
- Keep Stocks in the Portfolio – An age-old investment strategy has been to invest your age in bonds — in other words, at age 60, hold 60% bonds and 40% stocks and safer, lower return investments. However, if inflation is outpacing your bonds, you may want to keep a growth strategy for a longer time.
One way to do this is with a “through” target date fund, which alters your stock to bond ratio but does so to maintain growth past your retirement date.
In short – delay retirement if you can, and keep as much of your retirement stream as inflation-proof as possible. Delaying Social Security benefits is the least risky way to do that, but the other options above are all viable. Stay diversified to maximize your chances.
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