In 2021, inflation increased by 7% -- its highest point since 1982. This means that $1 at the beginning of 2021 was worth around $0.93 at the end of the year. While virtually everyone could feel this decrease in purchasing power, it's especially impactful for those in or nearing retirement.
Here's what the rise in inflation means for your retirement savings.
How the government uses inflation as a benchmark
Inflation is one of the benchmarks the government uses to determine whether they'll increase retirement account contribution limits and Social Security benefits payouts and if so, by how much. For example, from 2021 to 2022, the contribution limit for 401(k) plans increased by $1,000 to $20,500 ($27,000 if you're 50 or older). While IRA contribution limits remained the same at $6,000, the income limits for contribution eligibility increased.
Thanks to legislation enacted in 1973, cost-of-living adjustments (COLAs) are applied to Social Security and Supplemental Security Income benefits to ensure they keep pace with inflation. For payments beginning in January 2022, Social Security benefits increased by 5.9%. So if someone receiving Social Security benefits normally received $1,000 monthly, they could now expect around $1,059. While it doesn't completely make up for the 7% inflation increase experienced in 2021, it definitely helps.
The importance of investing for retirement
There's no one-size-fits-all answer regarding how much you'll need in retirement, but a good rule of thumb to follow is to aim to have 80% of your preretirement income to maintain your lifestyle. For instance, if you currently make $100,000 annually, you should aim to save $80,000; if you make $50,000, you should aim for $40,000; and so forth. With a median income of just above $67,000, this means most people would need over $1 million in retirement savings to ensure they don't outlive their savings.
Unfortunately for most people, it's nearly impossible to achieve these savings goals without investing. The average interest rate on savings accounts is currently 0.06%, which, although better than nothing, is far from ideal. If you were to have $10,000 in a savings account with a 0.06% APY at the beginning of the year, you would've only earned $6 in interest at the year's end. Even at normal inflation levels, 0.06% interest on a savings account would still be far from enough to help ensure you're not losing purchasing power on your money each year.
At 0.06% interest, an inflation rate of 2% means you're losing 1.94% ($1,940 per $100,000) in purchasing power annually. That's why it's important you're investing for retirement. Applying dollar-cost averaging into a low-cost index fund -- like the S&P 500, which historically returns around 10% annually -- can be the best way to achieve your retirement savings goals. Even at historical inflation levels of 7%, a modest 8% investing return would be enough to make sure you're not losing value in your retirement savings.
Focus on what you can control
All inflation isn't inherently bad. In fact, the government aims to keep inflation around 2% each year to avoid the economy slipping too far into a deflation cycle, which can be much worse. Still, seeing the real impact of inflation can be discouraging for many people, and rightfully so.
If you're fairly far out from retirement, the present rise in inflation shouldn't impact your retirement savings much, since you'll be trying your best to avoid spending the money. One of the best things you can do is make sure you're investing your money to keep up with (and hopefully surpass) the inflation levels. If you're currently retired, you may want to consider cutting down on spending until inflation has slowed down and your purchasing power has increased.