You've signed up for the 401(k), set aside as much as you can, and decided on a post-retirement budget. Feel prepared?
You should be feeling pretty good about life, but there's one major aspect of retirement planning that you've probably overlooked: inflation.
Why inflation matters
You might be laughing and thinking that inflation is hardly a threat right now.
And indeed, right now -- or even in five years -- you do have nothing to worry about. But the inflation rate is going to rise again, and even if it only averages 1% from now until the end of time, you're still facing a threat to your retirement.
That's because inflation is dangerous in the same way smoking is: You don't notice the effects day to day, except maybe the odd chest pain or the sudden realization that bacon prices have suddenly gone up up by a dollar. And one day, all of the sudden, it becomes real.
Just like smoking, that reality can take decades to manifest.
For example, say you've decided you can live off of $60,000 per year in retirement. At 1% average inflation, your purchasing power will have declined to the equivalent of $49,000 in 20 years.
In other words, take that $60,000 budget and lob off $11,000. That's the equivalent of what you'll have to spend in 20 years if you're on a fixed income.
And keep in mind that this is a best-case scenario. Take a look at the last 20 years of the consumer price index, which measures inflation in the goods and services most of us buy:
One thing you've probably noticed is that, while inflation isn't out of control in this period by any stretch, it's also not very stable. In other words, it's very unlikely to stay at 1% -- and even a small change can make a big difference.
Say, for example, that inflation averages 2%. In 20 years, your $60,000 will be worth just $40,000.
But wait -- there's more!
That calculation doesn't even take into consideration the individual inflation rates of specific costs. Most important among them? Healthcare.
A Genworth Financial survey found that the median cost of a private room in a nursing home rose 4% between 2012 and 2013. If that continues, the current median price of $240 a night will run you $525 in 20 years.
In the past five years, the overall health care inflation rate has hovered between 2% and 4% per year. Say in the best case that it remains at 2%; that means you'll need nearly 50% more cash in 20 years to cover your costs than you would today.
What to do
The key is to adjust your income and expectations for inflation.
The thing you most want to avoid is living off of a fixed income for your retirement. That means it's best for any annuities, pension payments, or other fixed income sources to come with an annual inflation adjustment, meaning the amount you receive is raised alongside the inflation rate.
If that's not possible, you need to account for the slow but steady decline in buying power that inflation brings. One way to do this is to supplement your fixed income sources with variable ones. For example, if you own rental property, you'll raise your rents every year (obviously, however, property comes with its own set of risks).
What if you're drawing down on your 401(k)?
Inflation acts as an additional drag on your performance, so it needs to be subtracted from any gains you've made in your account. In other words, if you had a great year and your account grew 10%, in reality, it only grew 9% in terms of purchasing power.
That's because every single year you're paying a roughly 1% fee to inflation. This fee accounts for the gradual loss of buying power that inflation brings.
It's not a big deal if your performance is positive and above the inflation rate, but it can become a problem if it isn't. So adjust your expectations accordingly -- and consider allocating more to equities than you expected to. After all, retirement can last you upwards of three decades, and you don't want to be caught without resources at the end of it.
