By Judy Loy,
Registered Investment Advisor, ChFC®, RICP® and CEO of Nestlerode & Loy, Inc.
What is inflation? Inflation is defined by the Fifth Edition of Dictionary of Finance and Investment Terms as the “rise in the prices of goods and services.” This is important for retirement because retirees and future retirees tend to ignore this in their retirement plans. As of November 2020, the U.S. annual inflation rate stood at 1.2%. Even with record amounts of cash flowing into our economic system and low interest rates in 2009 and today to rescue us from the real estate bubble and the COVID recession, we are not seeing high levels of inflation. Historically, Economics 101 tells us that such accommodative measures would lead to high levels of inflation. This has not happened.
Why is inflation important to you? Inflation lowers the buying power of your money. You may live comfortably on $75,000 now but even in 10 years (18 years is the average time in retirement) with the current low interest rates, you would need $89,475 to purchase the same things (based on inflation from 2010 to 2020, a cumulative 19.3% rate). Healthcare tends to be a large expense in retirement, and this runs at double the general inflation rate. This means someone with a fixed pension, such as PSERS, needs to plan how to compensate for inflation increases that their pension payment will not provide. A retiree with a pension needs to take the lump sum or have outside assets to assist with inflation increases over time. The lump sum can be invested to supplement their pension payments for inflation if investments are unavailable outside the pension plan.
One way to battle inflation in retirement is to invest for growth and income in equities. Stocks tend to be a hedge against inflation because corporate earnings grow faster when there is inflation. One of the key mistakes that retirees make is moving their investments too conservatively in retirement, which makes it harder to keep up with inflation.
Another way to mitigate inflation risk is to take social security payments as late as possible. Taking social security at the earliest age, 62, rather than full retirement, which currently ranges from age 66 to 67, decreases the benefit by 30%. Waiting until age 70 (the age at which benefits no longer increase) will increase social security payments by approximately 8% each year you wait from your normal retirement age. In addition, social security cost of living increases (a main way to fight inflation) will compound on a larger monthly benefit providing greater maintenance of purchasing power through retirement.
Planning ahead before retirement can be the most impactful for any retirement savings decisions. For instance, try to increase your contributions toward retirement every year. If you continue to save the same money amount, you’re not really saving the same amount; you’re saving that dollar figure minus what you’ve lost in purchasing power to inflation. To help put this on auto-pilot, make sure all your payroll deductions are set as a percentage of your salary rather than a fixed dollar amount.
Finally, the best way to fight inflation before and during retirement is by investing to obtain better returns than inflation. To better keep up your buying power, maintain a diversified growth portfolio even after retirement. Moving to a very conservative portfolio may mean you won’t lose market value but it might also mean you lose buying power. For instance, if you have $20,000 invested earning 2% and inflation runs at 3%, your portfolio would grow to $24,380 but your purchasing power would leave you with an inflation adjusted balance of $18,141.
When preparing for an enjoyable retirement, keep inflation in the frame. It is important to not only be able to buy necessities and cover expenses now, but also later in your retirement years. Therefore, take the time to run a calculator that includes inflation to be sure you are saving enough and make the adjustments to your portfolio and/or contributions to be sure you stay on track.