Retirement is all about taking your money and investing it to get a return that is better than inflation and taxes. So how can inflation affect that? Let’s look at a few examples. Suppose you have a $10,000 retirement fund that has returned 7% per year in retirement. Assuming you are good at planning and investing, that $10,000 will grow to over $14,000 at retirement. If you assume an annual inflation rate of 4%, that means that over time your $10,000 will grow to over $5,600. That means you have less savings than you thought, and the return on your investment is now lower than expected.
There are a lot of people who think that inflation only affects the price of goods, and they don’t realize that it also affects the value of their savings. Here are some facts about inflation that you might not have known: – Personal savings account with your employer will lose value due to inflation. -Anyone who put money in a bank savings account, mutual fund, or other investment over the last 12 months will see the value of their investments fall. – If you are planning on withdrawing money from your retirement account, and you have a 1 year rule, then your investment will lose even more. – If you have a one-year rule, then your investment will lose value by more than 1% every year. – Your
Before you retire, you have to be careful because inflation is one of the biggest risks to your retirement plan. You want to make sure your portfolio is adjusted for inflation before you retire. Inflation can contribute to your portfolio’s long-term stability and performance. Inflation will also help in the accumulation of wealth, since as a retiree you will be able to spend a smaller amount of money on a fixed amount of money.. Read more about how does inflation affect pension funds and let us know what you think.
When Bill Bengen, the financial planner who devised the 4 Percent Rule for safe retirement withdrawals, was conducting research, he discovered that two factors had a significant impact on a nest egg’s long-term viability.
Of course, the first was market returns. The higher the stock market rose, the more money people made, and the longer their retirement savings lasted.
However, inflation was another factor that was frequently overlooked. Retirees didn’t have anything to worry about during low-inflation years because their living expenditures scarcely altered. However, during periods of high inflation, such as 1974 and 1979-1981, when inflation was above 10%, this wreaked havoc on the finances of someone living on a fixed income.
I’d like to discuss about inflation and how it can effect your retirement goals in this piece. We’ll go through why you should be concerned, as well as what you can do to prepare.
What is the definition of inflation?
Most people are familiar with inflation as the annoyance of having to pay more for something this year than you did last year. Every time I go to one of my favorite restaurants, I think about this. A dish that used to cost $10 became $12, then $15, and finally $18 after a few years.
Of course, this isn’t limited to the food industry. It happens with everything’s price:
- Medical attention is provided.
- Fuel / energy
The reason inflation rises & the price of everything oges up year after year is due in part to micro changes in our economy. If workers in one industry get a pay raise or a particular material to make an item become more scarce, a company now has to pay more in expenses than it did before.
This eventually trickles down to the customer, meaning you’ll have to spend extra to make up for the difference. While there are many factors that influence inflation, one thing is certain: it will continue to climb year after year.
The government uses a statistic called CPI to track inflation as a whole (consumer price index). CPI is defined as the weighted average of a specific basket of goods and services that a typical customer would require. Transportation, food, and medical care are the most important factors.
One of the Federal Reserve’s numerous responsibilities is to ensure that prices remain reasonably steady and only increase at a moderate rate. They’ll use their ability to raise and cut interest rates to influence inflation and the overall economy as needed to keep prices in check.
What is the Cause of Inflation?
Inflation is a risk since it erodes the value of your money over time. The person who hides their money beneath the mattress because they don’t trust banks is a famous example. (And, yes, this is still done today.)
Someone who hides their money may believe they are being clever since their money will never go up or down in value; it will always be the same. But what they don’t realize is that this is merely the money’s “face” or “nominal” value, which is the number printed on the bill.
In actuality, because to inflation, that money will buy them less things than it would have 10 or 20 years ago. This is referred to as the “real” value of money, as it is the value once inflationary impacts are taken into account.
When I was trying to help my daughter find an apartment, I came across this firsthand. The average monthly cost of a unit is currently between $900 and $1,000. When I was in college, $1,000 would have paid for nearly two months’ rent.
Money has the same face value as before — $1,000 is still $1,000. However, the true worth of $1,000 is that it can now buy around half of what it could 20 years ago.
Why is inflation in 2021 so high?
If you look at historical data, the average rate of inflation for the last 100 years (1921-2021) is only 2.82 percent. When only the last 50 years (1971-2021) are included, the average rises to 3.89 percent. As a result, you could consider 3 to 4% inflation to be very “normal.”
If you’re anything like me, and you’ve tried to buy a car or wood from Home Depot in the previous six months, you’ve probably noticed that the prices of these and other things have skyrocketed. This isn’t a coincidence.
The 12-month CPI of all items increased by 5.4 percent, according to a recent study from the Bureau of Labor and Statistics. The most noticeable increases, when broken down, were:
- For used automobiles and trucks, the percentage is 45.2 percent.
- The price of fuel is 45.1 percent.
- Energy is worth 24.5 percent (commodities and services)
So, what exactly is going on here? Why has the cost of living grown so dramatically? As you can expect, the COVID-19 epidemic plays a significant role.
1. Demand has resurfaced!
For instance, when you compare costs this year to last year, the difference is night and day. Every state was on lockdown in some way, forcing many businesses to close their doors and cut back.
This was especially true for airlines and hotels in the tourism business. I recall receiving emails from a number of major airlines offering flights for as little as $50.
Fast forward to 2021, and business is once again booming. People are still shopping, eating out, and traveling like before. As a result, costs have risen by as much as 10% for rooms and as much as 24% for airlines.
2. Re-opening necessitates increased energy use.
One of the reasons why energy is so much more expensive is because of this spike in demand. The goods must be delivered to the stores, which necessitates the use of drivers. Heating and cooling are required in offices. Planes require fuel to operate.
As a result of many industries making a comeback, energy consumption is increasing. As a result, costs are skyrocketing.
3. Production Shortages
During the epidemic, there were additional supply issues due to the shutdowns. This is especially true when it comes to the production of new automobiles. Due to a lack of computer chips, production has slowed and many vehicle showrooms have become vacant lots.
With no new vehicles on the market, buyers are buying used cars at a faster rate than ever before. That’s why they’re willing to pay top bucks.
COVID Relief Funds are number four.
Finally, Congress has granted about $4 trillion in relief since the outbreak began. It doesn’t take a genius to figure out that putting this much cash into the economy will have an impact on the value of a dollar.
In a nutshell, this is because as more money is printed, more individuals will have access to it. The more people who have money, the less a dollar is worth in the long run. Everyone has it now, therefore it’s no longer a rare occurrence!
“There’s a strong probability that within the year, we’ll be dealing with the most serious incipient inflation crisis that we’ve faced in the last 40 years,” former US Treasury Secretary Larry Summers said on the subject.
What Is the Fed’s Role in Inflation?
Contractionary monetary policy is one approach the government might try to keep inflation under control. This is when they try to make it more difficult for people to spend money. When firms are unable to purchase goods, prices fall, and inflation falls.
This can be accomplished by the Federal Reserve lowering bond prices and raising interest rates. A bond is essentially a debt that you give to the government in exchange for the government paying you interest every year. While the Federal Reserve can’t force lenders to set interest rates at a certain level, they can set a benchmark for what they should be, which most lenders follow.
When they do, though, one of the immediate effects is usually a decrease in the stock market. This makes sense logically because firms will be less willing to spend and will want to save money.
This is something I’ve seen dozens of times in my adult life. The markets will typically fall back in panic before the Fed chairman makes his major, public announcement. After that, if rates do rise, the markets nearly usually fall considerably more.
Another weapon the government can use is to increase the amount of money banks must have on hand by imposing higher reserve requirements. The premise is that the more they have to withhold, the less they can lend to customers, resulting in lower expenditure.
What Impact Will Inflation Have on My Retirement Fund?
Inflation can be a genuine threat to anyone thinking about retiring or nearing their last day at work. Here are a few significant points to be concerned about:
Purchasing Power Has Dropped
One of the major risks of inflation, as we noted before, is that the money you’re saving now may lose its purchasing power. This implies that it will be valued less in the future than it is now.
Assume you set a $1 million retirement savings target when you were in your twenties and thirties. Over the following 30 years, you work and save to achieve that goal.
However, when you go home, you discover something unpleasant. Your $1 million may now only be able to buy $500,000 of the items you expected. This is because the cost of almost everything has doubled since you started saving: gas, groceries, utilities, insurance, clothing, and so on.
You may not trust me, but using the Rule of 72, we can rapidly verify this fact (a helpful back-of-the-envelope calculation that tells you how long it will take for an investment to double in value). Remembering that the average rate of inflation for all items is around 3 to 4%, dividing 72 by these figures tells us that inflation takes about 18 to 24 years to cause.
As someone in their early forties, I can relate to the fact that inflation is quite real. Rent has essentially doubled since I was in college, just as it did in my previous example concerning the flat.
I can only imagine how frightening that must be for someone who has been retired for 20 to 30 years and is attempting to stretch their funds as far as they can.
Reduction in the value of nest eggs
As previously stated, one of the ways the Federal Reserve will combat inflation is by raising interest rates. However, if they do, the stock markets may see a downturn.
If you’re like the average American and have most of your 401k and IRA invested in stock-based funds, your money will most certainly lose value. This is critical because you were counting on those savings to give you with the funds you needed to replace your income from work.
Although stock market declines are usually short-lived, it may take many months for market values to rebound to their previous highs. And if the Fed does this several times, it may take even longer for the economy to stabilize.
That could be problematic for someone approaching retirement or in their first year. For example, if they had saved $1 million and the markets fell 10% or even 20%, their savings would be reduced to $800,000 to $900,000. It’s terrifying to see 20% of your savings vanish in such a short period of time!
Savings for retirement are being depleted at a faster rate.
Whether it’s inflation eroding the value of your savings or the stock market reducing your nest egg’s value down to zero, all of this will put you at risk of depleting your retirement resources sooner than expected.
If you’re retired and living on a fixed income, the economy doesn’t give a damn. You’ll pay whatever it takes to keep your house warm if home energy rates rise. When grocery stores raise their prices, you’ll pay whatever you have to in order to eat.
This can be especially aggravating during periods when inflation rates are significantly higher than typical, reaching as high as 10% in the 1970s. The greater the rate, the faster your nest egg withdrawals would erode your assets, putting you at risk of running out of money in retirement.
What Impact Will Inflation Have on Social Security?
Every American’s retirement strategy should include Social Security. Despite the fact that the excess in the Social Security trust fund is expected to be spent by the year 2035, beneficiaries can still expect to receive roughly 79 percent of the benefits to which they are entitled. 79 percent is still better than nothing in my book!
Regardless, you’ll be relieved to find that inflation is already factored into your Social Security payouts as part of your retirement planning. Your benefits will be automatically increased each year in order to keep up with inflation. This is referred to as a COLA (cost-of-living adjustment).
COLA was founded in 1973. Prior to this, Social Security payouts were essentially fixed unless someone proposed new legislation to raise them every couple of years. This was a slow and inefficient system, which resulted in benefits rapidly losing purchasing power.
Then, in 1968, inflation began to spiral out of control. With inflation, things got out of hand in the 1970s. It crept up to 5.84 percent during the next three years. This sparked a furor over retirement benefits, prompting the establishment of the COLA mechanism to ensure that payouts kept up with inflation.
Is the COLA Keeping Up With Inflation?
Despite considerable COLA adjustments over the years (such as when it hit a record high of 14.3 percent in 1980 after inflation increased by 13.5 percent), there has been criticism. One of the most compelling arguments is that COLA does not keep pace with the genuine price of medical care, which is one of the most significant expenses for most seniors.
Is that even possible? To grasp the concept, think about how COLA is computed.
COLA is calculated using the CPI-W (Consumer Price Index for Urban Wage Earners and Clerical Workers) statistic from the Bureau of Labor Statistics. This is a variation of the CPI-U, which is more widely used and applies to all working citizens.
CPI does not directly price health insurance products in either situation. Despite the fact that the BLS recognizes that this is a significant investment, they have stated that they are unable to reliably account for changes in quality.
Costs have risen considerably, as anyone who pays attention to the health insurance premiums deducted from their paychecks each year knows! Premiums for family coverage have climbed by 22 percent in the previous five years and 54 percent in the last ten years, according to the Kaiser Family Foundation’s survey of employment benefits. That isn’t even close to the pace of inflation.
With a fast decreasing trust fund and a COLA that isn’t keeping up with one of America’s largest expenses, you can expect that adjustments to Social Security will be made in the coming decade. Keep an eye out…
How Should I Prepare for Inflation?
So, what are you expected to do about inflation, if it’s this big ugly monster that’s going to raise prices and make your life savings less valuable?
As it turns out, you have a variety of tools at your disposal to combat inflation. Here’s what you can do about it.
It Isn’t Something You Should Ignore
One of the most common mistakes I see clients make in their retirement plans is ignoring or entirely forgetting about inflation.
Why do people behave in this manner? Because inflation isn’t something that most people can touch or feel right away. Trying to visualize yourself at 60 years old and retiring is an abstract exercise, therefore it’s difficult for our imaginations to comprehend that a Subway sandwich may cost $20 in the future.
Both things will happen, believe it or not… even the sandwich thing. And we need to keep that in mind when calculating how much money we’ll need to save in our retirement accounts.
To assist you in determining this, I may suggest two techniques for planning your retirement with inflation in mind:
1) Inflation-adjust all of your monthly spending before adding them up.
Take each of your future living expenditures and increase them by 3 to 4% every year until the year you intend to retire. These computations will very certainly need the use of Excel or Google Sheets.
Once you’ve figured out all of that, add it all up, multiply it by 12, and then increase it again by 25. (to apply the 4 Percent Rule). Your inflation-adjusted nest egg savings goal will be the eventual result.
You might have imagined that $1 million would be enough to retire in the previous scenario. However, when factoring in inflation, it’s possible that all of your expenses will double in price. That means your emergency fund would need to be closer to $2 million (in future dollars).
You may then calculate how much you’ll need to save each month by considering the following factors:
- The number of years it will take you to retire.
- Your investment’s average rate of return
However, given the amount of money you’ll save each month is unlikely to be a fixed sum, this might become a little difficult. It will also increase with time and inflation, so these factors must be considered.
2) Subtract your return rate from inflation (this is my preferred option!)
Another, easier way to account for inflation is to leave your projected expenses and savings goal same in today’s dollars. If you think you’ll need $1 million now based on your costs, suppose you’ll need $1 million in inflation-adjusted dollars later.
So, if your spending are constant, how do you account for inflation? Simple: deduct it from the expected return on your contributions during your working years.
Assume you invest in a stock market index fund with a 10% average yearly return. However, if you deduct 3% for inflation, you may only be obtaining a true rate of roughly 7% every year.
You’re virtually transforming all future dollars into today’s dollars by doing so. Not only does this strategy require significantly less work, but I’ve discovered that it’s also far simpler for people to accept because the numbers you’ll come up with don’t sound as implausible.
Invest in Tax-Advantaged Accounts to Save Money
If you put your money in a bank account or invest with a traditional broker, you’re not getting the most out of your money.
Every year, the IRS allows every American to avoid paying thousands of dollars in taxes by allowing them to use their retirement accounts, such as their 401k or IRA.
Let’s pretend you’re in the 22 percent tax bracket to demonstrate this point. You might be saving the following if you maxed up your retirement plans:
- 401(k), 403(b), or 457(b): A maximum contribution of $19,500 per year results in a tax savings of $4,290.
- IRA: A maximum contribution of $6,000 per year results in a tax savings of $1,320.
- Plus, if you have a side hustle, a SEP IRA or Solo 401k can provide you with even more options!
Though you won’t be directly cutting inflation, you will be countering it by making your savings more efficient. Every dollar you pay yourself instead of the IRS adds up to a lot more in your savings account.
Invest for the Long-Term
Remember that money hidden under a mattress loses 3 to 4% of its value each year due to inflation. As a result, investing in securities that will yield the highest potential returns is a natural strategy to resist this tendency.
A great option would be to invest in a stock market index fund that mirrors the S&P 500 (such as Vanguard’s VFIAX). The long-term average return of these types of funds tends to be around 10 percent. That means with inflation you’d be making a real return of roughly 6 to 7 percent per year.
Compare this to someone who buys short and intermediate-term government bonds. Due to the Fed’s historically low interest rates, these types of bonds have struggled and delivered returns ranging from 3 to 5% on average over the last decade. Unfortunately, this is barely breaking even when compared to inflation.
Small-cap stocks are another asset class to examine if you’re willing to take a little more risk. They offer a higher long-term average return than large-cap stocks, despite their prices fluctuating more.
Take a look at the returns from 1966 to 2018 to get an idea. The return on small-cap stocks was 12.8 percent, while the return on large-cap stocks was 10.1 percent.
You Shouldn’t Pay Off Your Mortgage
In the world of personal finance, I realize it’s sacrilege to propose not paying off your mortgage. But bear with me. There is a possible advantage when it comes to inflation.
Consider all of your fundamental living expenses (food, gas, utilities, etc.). Each of these items will rise in price due to inflation over time. One of your expenses, though, will not go away: your mortgage payment.
If you take out a 30-year fixed mortgage to purchase a property, the principle and interest component of your payment will remain the same for the duration of the loan. That means that the longer you stay in your home, the less you pay on your mortgage in comparison to everything else.
Here’s an easy example. Remember how we showed previously that inflation doubles the price of everything after 18 to 24 years using the Rule of 72?
Consider the case of a $1,000 mortgage. All of your usual living expenses will have more than doubled in price after about 20 years.
Your mortgage, however, is an exception. It will remain $1,000, as it was 20 years ago. In fact, it will “feel” like you’re paying $500 when compared to your other expenses.
Of course, the longer you wait to pay off your mortgage, the more interest you’ll pay. So only utilize this strategy if you’re okay with that and are already preparing to pay off your mortgage as soon as feasible.
Inflation, a decline in the value of money over time, is a factor to consider as you plan for retirement. Although it may seem like we’re living in scary times, it’s important to remember that many of our daily conveniences are still affordable. For example, the average cost of a gallon of milk remains about $3.50, and an eight-pack of beer is only $4.50.. Read more about inflation and retirement and let us know what you think.
Frequently Asked Questions
How does inflation adjust for retirement?
Inflation is a tricky thing. It is a fact of economics that prices will rise over time. Compounded interest is the same. Inflation can have a negative or positive impact on a retiree. However, the biggest risk to retirees is the loss of purchasing power due to inflation. Q
Is inflation good or bad for retirees?
Inflation is a measure of the overall change in prices of goods and services. It is a kind of change in the currency value. For retirees, inflation is generally a bad thing as it erodes the value of their savings. Q: Can the United States have a debt ceiling? A
Does your pension go up with inflation?
Yes. As of 2018, the cost of living adjustment for retirees is calculated by the Chained Consumer Price Index for All Urban Consumers (C-CPI-U). Q: What is the best place to buy a usb charger for a cell phone? It is best to buy
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