When people review their retirement needs, they estimate their expected expenses and their lifespan and then set a target dollar value to meet that goal. Unfortunately, most people don’t take into account the time value of money, and how much the purchasing value of their retirement funds will change by the time they retire.
That is the effect of inflation – a significant and underrated threat to your retirement funds. The simplest way to consider the damage is to think of inflation as a baseline rate of return that your savings and investments have to generate just to break even.
Considering that the average inflation rate for the last 100 years is 3.33%, our current rate of inflation is relatively low at 2.1%. This is effectively the inflation rate that the Federal Reserve considers a target value for economic growth. While that may be good for the country as a whole, any inflation at all decreases your spending power.
The Consumer Price Index (CPI), a measure of the change of overall prices calculated by the Bureau of Labor Statistics (BLS), has risen an average of 4.15% over the last 50 years. At that rate, the spending power of $100,000 when you start requires $276,000 in 25 years and $763,000 in 50 years!
During your working years (in theory at least), your wages rise over time to compensate for this. However, in your retirement years, you are dependent in the cost-of-living adjustment (COLA) in Social Security to account for inflation – and it does not keep up, even during these times of relatively low inflation. According to studies from the Senior Citizen’s League, since 2000, the purchasing power of Social Security benefits has been reduced by over 31%.
Why doesn’t it keep up? The Social Security COLA is based on the change in the CPI-W, one of the forms of the Consumer Price Index. The CPI-W is cumulative in nature, covering everything from the price of cars and TV sets to staples such as milk and eggs. Unfortunately, staples and other items important to a retiree’s daily expenses are rising faster than larger purchase items.
Most financial plans shift retirees into more conservative funds to avoid any potentially large losses in the stock market that they may not have time to recoup. However, if the funds are too conservative to outpace inflation, they are in effect losing money.
For example, from 2004-2013 the average annual return on 3-month Treasury bills was 1.54%. Meanwhile, the average rate of inflation during that same period was approximately 2.4%. For comparison, 10-year Treasuries averaged 4.69% and the S&P 500 yielded 9.1%.
Now that you know about the effects of inflation, what can you do about it?
You can purchase investments that are inflation adjusted, such as TIPS (Treasury Inflation Protected Securities). These are government-backed securities that pay interest twice yearly, with a principal that rises or falls with the inflation rate. Unfortunately, these have the same limitations as the Social Security COLAs, and do not always provide the best returns. Typically, inflation needs to be around a steady 4-5% for these investments to pay off.
You can also delay retirement or delay taking Social Security benefits until age 70 to increase income, but these may not be palatable options to you.
The best advice is to not let your investments become too conservative. Take an active role in your investment management, keep the ratio of stocks to bonds/cash high enough to maintain a cushion above inflation even in your retirement years, and rebalance your portfolio regularly. Balance this with the risk you can tolerate, and if you cannot tolerate the necessary higher risk, then scale back your retirement goals.
You cannot affect inflation and the prices you pay for your staples, but you can maintain your investments throughout retirement to keep a focus on a decent return instead of a reliance on a fixed income. Remember, your income may be fixed, but prices are not – and you know which direction they will go.
Let the free Retirement Planner by MoneyTips help you calculate when you can retire without jeopardizing your lifestyle.