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There are two things we must know about our sources of income:

1. Whether or not they will increase with inflation, and

2. Whether or not they will pass to a survivor in the event we die.

Think about these issues for a bit, and you'll easily understand why both are important in our planning. Consider a $1,000 monthly income that fails to increase with the cost of living (assuming inflation runs 4% annually). That $1,000 will only buy $555 of today's goods in 15 years. To protect our purchasing power in the future, we must save enough today to be able to increase our income in retirement. Either that, or cut back to 55.5% of the caviar and champagne we're currently tossing back nightly.

Let's look at our five sources of income in relation to inflation:

We can say that Social Security will likely keep pace with inflation. That's because Congress has never failed to increase benefits each year to reflect changes in the cost of living. That's not to say someday they won't do so, but just that over the past four decades they never have. So that's the assumption we're going to make. Also, on your death, Social Security benefits may be payable to children and to your surviving spouse, depending on their ages and, in the case of your spouse, whether or not you were the primary wage earner.

An employer-provided pension, or defined benefit plan, may or may not increase with inflation. That depends on the plan itself. Be aware that most do not. And even those that do rarely provide a full cost-of-living adjustment. Instead, the increase is typically limited to one-half of the annual inflationary increase as measured by a common index such as the Consumer Price Index (CPI). And, unless you specifically declined the option, at death it will always provide a continuing lifetime benefit for your surviving spouse.

Savings may or may not keep pace with inflation. That, dear Fool, is a function of how you invest those monies. Keep the investments largely in fixed income vehicles, and chances are strong that the nest egg will not maintain its purchasing power over the years. (Naturally we're big on investment returns here at the Fool, and lessons on that subject are right around the corner.) Savings will always pass to your heirs at your death.

When it comes to work and other income, the issue of keeping pace with inflation becomes more difficult to pin down. You'll always be the one to judge whether or not you're being paid fairly for your work. Other income, such as that coming from the sale of collectibles (like your sister's coin collection), may or may not do so. What passes to whom on your demise, of course, depends on how you hold title or what you've provided for in your last will and testament.

These, then, are the five primary sources of income in retirement and the features you should consider during your retirement planning. In Lesson 4 we'll get to investment vehicles and returns.

« Five Income Sources

Lesson Summary »