Retirement planners say you should plan for retirement living expenses of 80% to 100% of your working salary, but that could put you in the poorhouse if retirement is decades away. Why? Because inflation is slowly eroding your purchasing power over time. Your salary today might be sufficient to cover your living expenses, but you'll need far more in 30 years. Specifically, annual living expenses of $50,000 today will cost $104,000 by 2050, assuming inflation of 2.5%. That's a $54,000 increase, without any change at all to your lifestyle.
You may not think about inflation much today, because it's far easier to manage when you're earning a paycheck. You probably get an annual raise that keeps your income growing roughly in line with inflation. And now and again you might get a promotion that comes with a bigger salary increase, which funds things like a bigger house, a nicer car, or a fancier vacation. But those raises and promotions go away once you retire.
Social Security recipients do get cost-of-living adjustments. These are based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). Unfortunately, the CPI-W in recent years has been much lower than the inflation rate of Medicare premiums, which is a primary expense for most seniors. For example, the 2021 Social Security COLA is 1.3%, but the current healthcare inflation rate is above 4%. Where that difference creates an income shortfall, retirees have to make it up by cutting other costs or taking higher savings distributions.
You should be able to make small inflation adjustments to your retirement distributions each year, but large ones can threaten your future solvency. For that reason, it's wise to build some extra inflation protections into your portfolio now. Here are four ways to do it.
1. Invest in equities
Stocks are a good inflation hedge because they tend to grow faster than inflation. Long-term, the stock market averages annual growth of about 10%, which compares to long-term inflation rates of 2% to 3%. The simplest way to access those long-term growth rates -- which net out to about 7% -- is to buy high-quality stocks or funds and then hold onto them for decades. A low-cost S&P 500 index fund, for example, would give you near-market-level returns as long as you remain invested in it.
Stocks that reliably increase their dividends are also good choices. These provide two ways to earn, through rising dividend income and stock price appreciation. You can reinvest dividends while you're still working and then take them in cash after retirement. The resulting cash flow can fund a part of your retirement distributions, which helps you keep liquidations to a minimum.
You can find companies with a history of raising their dividends on the Dividend Aristocrats index. To qualify as a Dividend Aristocrat, a company must be part of the S&P 500, meet certain market capitalization and liquidity requirements, and have 25 consecutive years of dividend increases.
2. Buy TIPS
TIPS are Treasury bonds that are tied to inflation as measured by the Consumer Price Index (CPI). When inflation rises, the principal value of the bond is adjusted upward. This in turn raises the bond's interest payment, which is calculated by the coupon rate applied to the bond's adjusted value. If inflation decreases, the bond's value and income will also decrease, but the downward adjustment will never drop the bond's value below your initial investment.
TIPS pay interest every six months and are available in five-, 10-, and 30-year maturities. Unfortunately, the current coupon rates are fairly dismal, less than 0.2% for five- and 10-year maturities. Moreover, they're currently priced so highly that they effectively offer negative interest rates after accounting for inflation.
You can buy TIPS direct from the government at TreasuryDirect, or you can buy shares of a TIPS mutual fund or exchange-traded fund.
3. Delay your Social Security
You can claim Social Security as early as age 62, but you'll benefit from waiting at least until you reach Full Retirement Age (FRA). Your FRA is based on your birth year and, for future retirees, is between the ages of 66 and 67. When you file for Social Security before FRA, your benefit can be reduced by up to 30%. Holding out for the higher benefit eliminates the early filing reduction and increases the dollar value of your future COLAs. As an example, say your monthly benefit at FRA is $1,500. At that benefit level, a 2% COLA increases your Social Security income by $30 monthly. But if you claim early at age 62, your benefit could be as low as $1,050. From that base, your 2% adjustment is only worth an extra $21 monthly.
4. Increase savings contributions
If you are investing your retirement contributions (and you should be), raising those contributions builds your base of wealth-earning assets. The more money you have invested in positions that outpace inflation, the more flexibility you'll have going forward. You can create a nice financial cushion to protect against any financial uncertainty, including inflation, by buckling down and adding an extra $50,000 or $100,000 to your retirement portfolio before you leave the workforce.
That extra dough will make a difference over the course of your retirement, too. $100,000 invested conservatively for 5% growth will grow to $446,774 over 30 years. Or you can invest in a dividend payer like 3M (NYSE:MMM) and use the cash as income. At its current share price, $100,000 worth of 3M shares produces dividend income of about $3,600 per year.
Inflation is a real threat
Inflation can quietly undermine your retirement plan if you're not prepared. Protect yourself by investing in equities, including those that pay dividends, and TIPS. Waiting to claim your Social Security also works in your favor by increasing your base income and the dollar value of your future COLAs. And lastly, the cure-all for most retirement plan woes is to save and invest more while you're still working. You'd be hard-pressed to find a retiree who over-saved and now regrets it.