Investors often worry about market crashes and interest rate changes, but there's a sneakier threat that can be just as damaging to a portfolio: inflation. This is especially true when that portfolio represents your retirement savings.

Inflation is an increase in average prices caused by a decrease in the value of the dollar. While that sounds bad for consumers, moderate inflation is actually a sign of a healthy economy and usually goes hand-in-hand with a booming stock market and thriving businesses.

Why inflation is a problem

Inflation acts as a drag on the value of long-term investments. The average rate of inflation in the U.S. since 1913 is just over 3% a year. This means that you should anticipate the purchasing power of the dollar to drop by roughly 3% every year over the long term.

Graph showing 5-year inflation rate

Image source: FRED.

This is a problem for retirees because once you retire, you're living off the income your retirement accounts generate -- in addition, of course, to Social Security benefits. And if the income these accounts generate is worth 3% less every year, you could eventually end up with a shortfall. That's why many online retirement calculators factor in inflation when determining how much money you'll need to save for retirement.

Three percent is just an average. In any given year, inflation could be more or less than this. It's even possible to experience one or more years of deflation -- during which the dollar increases in value and prices tend to drop. However, if your goal is protecting your retirement income, you're looking at a long enough time window to safely rely on the 3% average.

How assets react to inflation

When it comes to inflation and retirement, you do have two pieces of good news. First, because moderate inflation is good for businesses, it tends to support higher stock prices. As a result, keeping a significant percentage of your retirement savings in stocks (say, 40% to 50%, depending on your risk tolerance) can help your returns grow faster than inflation. Second, Social Security benefits are indexed for inflation, meaning they go up each year based on price appreciation.

When inflation rises, by contrast, bonds get hit with a one-two punch. Interest rates tend to rise when inflation does, and the bonds you bought at 5% interest will be worth considerably less if new issues are paying 7% or 8% interest. And while your bond interest payments will stay the same, they won't be worth as much because the value of the dollar is dropping.

Consider buying inflation protection

One way to get around this dilemma is to buy inflation-protected bonds. The government-issued versions of these securities are called Treasury Inflation-Protected Securities (TIPS), and they are currently issued for terms of 5, 10, or 30 years.

TIPS are linked to the consumer price index, the official inflation measurement report issued by the Bureau of Labor Statistics. The principal balance of TIPS will increase as inflation rises or decrease during periods of deflation. At maturity, you receive either the adjusted principal or the original principal, whichever is greater. The interest rate won't change, but the amount of interest you receive until maturity will go up or down as the principal does. You can also choose to invest in an inflation-protected bond mutual fund, of which there are several options.

Whether you invest directly in inflation-protected bonds or in a mutual fund consisting of the same, be aware that the interest rate offered on such bonds is typically lower than standard issue bonds of the same type. In essence, you're paying for the inflation protection with a lower interest rate. If you think inflation is likely to rise, or you consider it a worthwhile price to pay for peace of mind, inflation-protected bonds are probably the way to go.

If you ignore it, inflation can take a serious bite out of your retirement savings and income. But if you're prepared and take measures to protect your assets, you can minimize inflation's damage and possibly even make it work for you (by investing in assets that benefit from inflation, for example). That way you can sit back and enjoy your retirement, instead of wondering if your income is about to dry up for good.

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