You've seen the inflation headlines. According to the Consumer Price Index (CPI), prices have risen 5% or more versus the prior year for three consecutive months. For context, the inflation rate between 2012 and 2020 never rose above 2.9%.
The higher inflation trend won't last forever, but even a temporary inflation spike slows the growth of your retirement savings. The effect can be direct or indirect:
- Directly, higher inflation means increased costs for businesses. That often limits earning growth and stock price appreciation.
- Indirectly, inflation cuts into the purchasing power of your savings. You know this intuitively, but you may not have quantified the effect. You can do that by measuring the real rate of return in your retirement account, which is your investment return less inflation. If your 401(k) grows 10%, but inflation was 4% in the same period, the purchasing power of your savings only grew 6%.
At this point, you might be thinking: That's all well and good, but how do I protect myself from these bouts of high inflation? Here is your answer -- three strategies that'll help combat inflation risk in your retirement savings.
1. Save more than you think you need
When the purchasing power of the dollar falls, you need more dollars to buy things. That's a simple explanation of inflation -- an explanation that also hints at the solution. Saving more dollars gives you a cushion to fund higher-than-expected living expenses.
The sooner you increase your savings contributions, the more they'll grow, and the bigger a financial cushion you'll have in retirement.
2. Invest in dividend-paying stocks
Dividend-paying stocks deliver a one-two punch against inflation. First, while you are working, you can reinvest your dividends and watch your stock shares increase in number and value. Then, once you retire, the right dividend stocks should produce retirement income that also rises over time.
Of course, realizing these benefits is dependent on the stocks you choose. Lean toward high-quality, mature companies that have long track records of profitability, cash flow, and rising dividends. You may want to start your research by looking at Dividend Aristocrats and Dividend Kings. Dividend Aristocrats have increased their dividends for 25 or more years consecutively, while the Kings have raised their dividends for 50-plus years in a row.
3. Consider a bucket strategy
As you age, the usual approach to investing is to reduce your risk by lowering your equity exposure. Doing so protects you from short-term volatility in the stock market. Unfortunately, this approach can also lower your defenses against inflation -- since stocks are better at outpacing inflation than bonds.
An alternative is a bucket strategy. This involves segmenting your savings into three buckets, so you can invest more aggressively at an older age without risking a short-term liquidity crisis. Your three buckets might look like this:
- Short-term funds. This is a cash account. If you are at or near retirement, you'd keep a balance high enough to cover two years of living expenses. If you are 10 or more years away from retirement, you can get by with a cash balance that will fund six months of living expenses.
- Medium-term funds. You can invest this bucket in high-quality bonds, stable value funds, and blue-chip stocks. Your reliable dividend payers can live here too. Your medium-term funds should be sufficient to cover 10 years of living expenses.
- Long-term funds. You can invest your long-term funds in growth stocks. Depending on your risk tolerance, you might want exposure to small-caps, mid-caps, international markets, and other segments that can show high growth rates along with volatility. If you set up your short-term and medium-term buckets properly, you'll have a 10-year window to ride out the turbulence in this section of your portfolio.
Fight back against inflation
Inflation works against your retirement savings efforts by suppressing the growth of your purchasing power. You can't control the rise of inflation, but you can fight back. Saving more than you think you need, adding quality dividend payers to your retirement portfolio, and using the bucket strategy to invest more aggressively are three moves to consider.
Implement all three and, hopefully, you can emerge victorious in retirement, with enough wealth to fund the lifestyle you want.