There are two main drivers of asset class returns: inflation and growth. -- Ray Dalio 

Ray Dalio should know something about investment returns, as he started the Bridgewater investment company in a small apartment in 1975, and Bridgewater now encompasses the world's largest hedge fund, worth many billions. Unlike Dalio, many investors underappreciate the role of inflation in their investments and how it has a negative impact on purchasing power. It's especially harmful to those living on a fixed income in retirement.

Word Inflation on up trend arrow, with financial data visible on the background.

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Here's a closer look at inflation and its role in your financial life and retirement.

Incredible shrinking purchasing power

Most of us are familiar with the way that prices for all kinds of things tend to go up over time. Maybe you remember buying a nice new car for $10,000 years ago while a similarly nice new car today might sell for $20,000. If you expect to travel in 25 years, know that a plane ticket that costs $400 today could cost $800 or more in 25 years. That's inflation.

Inflation can be measured in various ways, and the most common measure of it is the "urban" (i.e. non-farmer, non-military, non-institutionalized) Consumer Price Index (CPI), which measures, year by year, the cost of a basket of common goods and services we Americans purchase. Those goods and services include food, clothing, housing, medical care, energy, and so on.

As prices for things rise, it challenges a fixed income -- which is, in part, at least, what many people live on in retirement. Social Security benefits are adjusted to account for inflation, but many annuity payments and other payments are not. If you receive, say, $4,000 per month and your monthly expenses are just about that, you'll be in trouble when property taxes, insurance premiums, food, utilities, gas, clothing, medical bills, Internet service, and many other expenses rise in price over time. 

The word "real" in 3-d letters

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Inflation: nominal vs. real returns

Over long periods, inflation has averaged about 3% per year, but in any given year or period, it can be much higher or lower than that. In 2015, for example, it averaged close to 0%, while it was 6% in 1982, 9% in 1975, and more than 13% in 1980.

When it comes to investing, and to estimating how much money we'll have in the future, it's common to overlook inflation and its effects. When you read, for example, that the stock market has averaged annual returns of close to 10% over many decades, that's not including inflation. That's what's called a "nominal" return, as opposed to a "real" return, which does incorporate inflation.

Check out the following data from Wharton Business School professor Jeremy Siegel, who has calculated the average returns for stocks, bonds, bills, gold, and the dollar, between 1802 and 2012 -- yes, more than 200 years! He offers his results in both nominal and real terms:

Asset Class

Annualized Nominal Return

Annualized Real Return

Stocks

8.1%

6.6%

Bonds

5.1%

3.6%

Bills

4.2%

2.7%

Gold

2.1%

0.7%

U.S. Dollar

1.4%

-1.4%

Source: Stocks for the Long Run, by Jeremy Siegel.

Clearly, inflation really shrinks one's results. Ignoring its effects puts you at risk of not having saved enough for retirement.

Including inflation in your retirement plans

Here are some ways to incorporate inflation in your thinking about and planning for retirement:

We can't know what the rate of inflation will be in future, years, so it's reasonable to assume the annual average of 3% -- or, if you want to be conservative and err on the side of caution, 4%. If you're earning less than the inflation rate from your investments -- say, in bonds or money market accounts -- then you're losing ground and your investment's purchasing power over time is shrinking, not growing. If you're averaging 8% annual growth, understand that it may be more like 5% in "real" terms -- i.e. with inflation factored in.

For example, imagine planning to save and invest $10,000 per year for 20 years and expecting it to grow by an annual average rate of 8%, culminating in a total value of about $494,000. That is the sum you can expect in 20 years. But in 20 years, $494,000 won't buy what it used to buy. If your $10,000 annual investments grow by an inflation-adjusted 5% instead, then your end number becomes about $347,000. You will actually still end up with that $494,000, but it will buy you roughly what $347,000 would buy you today, because most things will cost more.

There are lots of calculators online that can help you incorporate inflation into your retirement calculations -- like this one:

 

* Calculator is for estimation purposes only, and is not financial planning or advice. As with any tool, it is only as accurate as the assumptions it makes and the data it has, and should not be relied on as a substitute for a financial advisor or a tax professional.

Tiny shrunken dollar held in fingers

Image source :Getty Images.

What to do about inflation

Here are some ways to deal with inflation in your investments and retirement plans:

  • Invest in healthy and growing dividend-paying stocks. Ideally, the stocks will rise in value over time, while paying you cash every month or quarter or so. The upside here is that dividends also tend to be increased over time, and they often keep up with or exceed inflation. Imagine that you have $300,000 invested in a portfolio with an overall dividend yield of 3%. That would generate $9,000 in dividend income this year. If those payouts are upped by an overall annual average of 5% over a decade, they'll approach $15,000 in 10 years.

  • You might also set yourself up with some dependable annuity income in retirement. If you're looking at annuities, it's often best to favor fixed annuities over variable or indexed ones. Note that you can often have your annuity payments adjusted over time for inflation, if you pay extra for that feature. It can be worth it, over a long retirement.

Keeping inflation in mind as you plan for and save for retirement can help you encounter fewer unpleasant surprises in the future and can make your retirement more comfortable.

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