For much of the developed world, rampant inflation isn’t much more than a distant memory. In the United States, inflation has been fairly benign since the double-digit levels of the early 1980s. You have to go back to the early ’90s to find a year with over four percent inflation.
But that doesn’t mean it’s gone. And it doesn’t mean it can’t come back. Even our current moderate level of inflation has a significant impact across longer time frames. Properly dealing with inflation and its effects can make or break a retirement plan.
What Is Inflation?
Inflation is a general increase in prices. In the U.S., the government measures and reports changes in inflation as the consumer price index (CPI). Increases in prices will decrease the purchasing power of dollars.
For example, if you have $10,000 at the beginning of a year, and all prices increase by three percent during the year, your $10,000 will buy less at the end of the year.
You would need $10,300 — three percent more — to buy the same things you could of at the beginning of the year.
The effects of inflation are more insidious across time. At a seemingly low rate of three percent, inflation will double your costs in approximately 24 years. Putting it in terms of dollars, in 24 years, it will take twice the amount of money to do the exact same things you do today.
So even at low levels of inflation, costs can triple or quadruple during retirement. If you’re not prepared to spend three to four times more later in retirement, you should be prepared to live on far less. That’s the stark reality.
Why Do We Have Inflation?
When there is more demand for something than available supply, those who have the item charge more for it. If demand increases faster than the ability to produce increases, costs will go up.
Some inflation comes from increases in the cost of raw materials or production. These increases get added to the final product in the form of higher prices.
There’s also some built-in inflation. People expect prices to trend up, so they expect raises to compensate for these increased costs. This way, they can at least maintain their standard of living.
Increased wages are an increase to companies’ costs, so they raise prices to compensate for their increased expenses. And the cycle continues, with costs and wages each rising to compensate for the other going up.
The government can also contribute to the problem. When governments increase their countries’ money supply absent other changes, prices go up. Basically, it causes there to be more money representing the same economic worth. As a result, prices need to increase to offset the additional money in circulation.
Naturally, this ability to influence inflation through monetary policy works in two directions. In the U.S., the Federal Reserve has done an excellent job of keeping inflation in check across the last 30-plus years.
Inflation affects not only your retirement, but all aspects of our economy.
In the U.S., as in other countries, spiraling debt is a big consideration. The U.S. can’t sustain deficit spending indefinitely. There will come a day of reckoning. And with that will come rampant inflation.
Investments to Counter the Effects of Inflation
Most people wouldn’t consider a dramatic reduction in lifestyle across their retirement years as a palatable option. The antidote to the erosion of purchasing power is growth. The stock market is the most viable method for most investors to achieve returns in excess of inflation across long time periods. But there are other options.
One of them is treasury inflation protected securities (TIPS). These are treasury securities designed to provide protection against inflation. As a treasury security, TIPS are a pretty safe investment. They pay interest, and the principal value increases based on CPI.
Unfortunately, the inflation adjustments to principle are taxable, even though you wouldn’t realize the gain until sale or maturity. This makes them far less effective outside of a tax-deferred retirement account.
The biggest drawback to TIPS when considering them as an alternative to stocks for inflation protection is their lack of an upside. You can have great years with stocks, but your upside is far more limited with TIPS. They provide protection against inflation with low risk. For most retirees, that won’t be enough.
What’s a Reasonable Long-Term Rate?
Many financial advisers run long-term retirement projections using rates of three or four percent. That’s not unreasonable. We can’t say for sure what inflation will be — that’s what makes it such a problem. Looking backward, as advisers are prone to do, three or four percent is likely a good assumption.
The key to planning is to be prepared for a number of scenarios.
This should encompass some less likely possibilities. For example, there’s a chance, albeit a low-probability one, that long-term inflation rates will be five percent or higher. That doesn’t mean that it’s better to use a higher rate in your planning. However, it would be a good idea to know at what point inflation becomes an issue for your plans.
If you calculate you can afford to retire with a long-term inflation rate of four percent, consider what happens at five or six percent. It’s not that you need to be able to afford your retirement lifestyle at a higher long-term inflation rate. Rather, you need to know that things would change for the worse and have some idea of what that would look like.
As it is in many financial matters, knowledge is key in dealing with the effects of inflation.
Understanding that inflation is always a concern on a long-term basis is important. Knowing that you have investment options to work with allows you to position yourself with some degree of protection against the effects of inflation.
And knowing that you may have to make changes to your planning if inflation gets a bit higher helps you prepare for the less likely scenario of higher long-term rates.
Given this, you might want to regularly check in on your retirement accounts to make sure that they continue to perform well compared to inflation.