People often treat their retirement savings plans as if inflation isn't a factor, but it is certainly is. Over the past three decades, annual inflation has been about 3%, on average. It's incredible that we don't give inflation its due attention for all the hand wringing we do to stretch our money further in other ways.
Inflation gradually pushes up the prices of goods and services, and your money won't go as far if you ignore it. If inflation occurs at the average rate in 2019 and 2020, it will cost you 6% more to purchase the same goods and services in 2021 than it does right now.
If you're shopping for a big-ticket item that costs you $1,000 today, it would cost you roughly $1,061 by 2021. While that sounds minor, it only factors in two years of rising prices. In 30 years, a purchase that costs $1,000 today will cost more than $2,122, thanks to the cumulative effect of inflation.
Inflation isn't restricted to daily purchases and costs, because it also has a big impact on your retirement savings, in three major ways:
1. Inflation erodes the value of investments and savings.
If you're among the many folks socking away money in investments and savings for retirement, you need to be aware that inflation will effectively diminish their value over time. If you've saved $5,000 per year for 30 years, for example, you'll have a nice $505,365 at the end of the period, assuming an average 7% return each year, an average for the stock market. Sounds impressive, doesn't it? And it is.
But it's also not as much as it seems at first blush, because of inflation. The future value of the $505,365 will be roughly the value of $208,204 now. You'll be sitting on the same pile of dollars, but they'll purchase less than they do now, because of inflation. Put another way, the costs of goods and services will be steadily advancing because of inflation, so you'll need to meet the price tags of the future.
2. Cost-of-living adjustments for Social Security don't keep pace with inflation.
Social Security is a money mainstay for many senior citizens, but Social Security benefits are also subject to inflation.
Inflation is one of the reasons that Social Security benefits get periodic cost-of-living adjustments called COLAs. In fact, the Social Security Administration (SSA) just awarded recipients the highest COLA in seven years, a 2.8% adjustment for 2019.
While COLAs are a good thing, many observers think the benchmark the SSA uses actually underestimates the actual pace of inflation, especially for seniors. The SSA measures price changes every year by looking at the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Then it determines whether a COLA is needed, and how much any adjustment should be.
But the CPI-W underweights certain sectors that have experienced very steep price increases. For example, healthcare expenses have risen far more steeply than other sectors. The price of prescription drugs climbed 188% from 2000 to 2018, according to the Senior Citizens League. As a result of the relative underweighting, the purchasing power of Social Security actually fell 34% in that period, despite steady COLAs. So while Social Security is a valuable tool to manage retirement, don't expect it to keep up with inflation, and plan accordingly.
3. Investment choices need to factor in inflation.
So what do you do once you realize inflation is rising steadily and Social Security won't keep up? The prudent thing is to keep inflation in mind when picking investments. Bond yields and CD interest rates of return can be much lower than the inflation rate. In the past decade, for example, both have been under 2% at times, which is effectively a negative rate of return once you factor in inflation.
Stocks are one of the few investments with returns that outpace inflation, as the U.S. stock market has returned an average of 7% over time. But stocks are not without downside risk.
Investors are often advised to place part of their portfolio in fixed-income instruments, such as bonds and bank certificates of deposit (CDs), because such fixed-income investments are less volatile than the stock market, and they offer protection against a market downturn.
Dividing portfolios between stocks and fixed income is one way to take advantage of stocks' historically strong returns that handily thump inflation rates, while also enjoying the stability of fixed-income instruments.
A good rule of thumb is to subtract your age from 110. The result is the percentage of your portfolio to invest in stocks, and the rest goes to fixed-income investments. A 30-year-old would invest 80% of their portfolio in stocks and 20% in fixed income, while a 70-year-old would place 40% in stocks and 60% in fixed income.
Employing this allocation rule ensures your portfolios is protected from inflation, as much as possible. Folks with a long time horizon can benefit from gains made in the stock market while also being insulated from its risks. Older people living on a fixed income are more protected from dropping markets, while still being able to benefit from rising ones.