how to protect your retirement from inflation

The rise of inflation can have a serious impact on your retirement plan over time.  Throughout history, inflation has averaged 3.8% a year but as recent as July 2022, the inflation rate is 8.5%, the highest level since 1981.

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What is Inflation?

Inflation is the increase of the cost of goods and services over time.  Every month, the Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track these fluctuations.  The information is gathered from categories such as food and beverage, housing, apparel, transportation, medical care, recreation, education and more.  

What are the Risks of Inflation?

The number one risk is the loss of purchasing power.  Generally, you first start noticing it in your grocery bill.  Everything from meat to dish soap is now more expensive than before.  Gas is more expensive as well as going out to dinner.  When you’re in retirement, the budget that you follow is now increasing each month due to the cost of goods and services going up.  If inflation stays up for an extended amount of time and you haven’t planned for this scenario it can spell disaster. 

Another risk is the impact on your savings in retirement.  Most retirement plans are based on a set amount of income coming in each month against a set amount of monthly expenses.  Often there is a “cushion” of funds between the income and expenses that folks will use to increase their savings or emergency funds.  However, if that cushion gets used to meet monthly expenses, savings aren’t growing as quickly and could be decreasing.

Rising interest rates can be another risk.  Throughout history, the Federal Reserve has increased interest rates to slow spending and bring down inflation.  If you are retired and debt free, this risk will not apply to you.  If you are retired with an adjustable-rate mortgage, looking to finance a new car or carry balances on your credit cards, then the increases in interest rates is going to affect you.  As the Federal Reserve increases interest rates, so do the banks and finance companies so you’ll end up paying more.  Now the silver lining with increased interest rates is that banks will pay more on services like checking, savings, money market and CD’s.

For retired folks Social Security offers cost-of-living adjustments (COLA) which can increase your payment in years of high inflation and help offset some of the uncertainty.  Some pensions have COLA’s but may not be high enough to completely offset inflation.  Some pensions do not have a cost-of-living adjustment (COLA) at all.  

Inflation can reduce the real rate of return on your savings and investments.  When considering your real rate of return on your savings and investments, you’ll want to factor in inflation as well as taxes.  When doing so, this will reduce your absolute net return.

How do you protect your retirement from the impact of Inflation?

During a higher-than-normal inflationary period, you might be panicking because not only are the cost of goods going up, but the stock market can get jumpy and react negatively.  This is generally caused by the Federal Reserve being aggressive with interest rate hikes as they try to tame inflation.  

Your best course of action is to stay the course with equities because it’s been proven that the stock market is the best medicine for high inflation.  Now with that said, you want to make sure your portfolio is diversified and has a solid allocation based on good quality companies.  There are no guarantees attached to the stock market, but history has shown that the return on equities has averaged 10% since 1926 which outperforms the inflation average over that same time.

Be mindful of your spending.  In retirement, it might be difficult to increase your income, but it may be possible to cut down on a few optional expenses. When you see prices at elevated levels, it is a good time to track your expenses and find things that you can limit or eliminate.    

The flooring method to the rescue.  The flooring method is an idea that states you cover all your fixed monthly expenses with a lifetime income solution.  There are three items that will pay you a lifetime income that you can’t outlive: social security, pensions and annuities.  The way this method works is you look at your expenses and determine which one’s are fixed expenses each month.  This could be your utilities, cell phone bill, perhaps a small mortgage, gas and auto expenses, food related expenses, etc. Now some of these bills aren’t going to be exact each and every month but these are the bills that come in monthly that you need to cover.  Take the total amount of fixed expenses and compare that to your social security.  If your social security doesn’t cover all your expenses, then, if you have one, look at using your pension to cover the difference.  If you don’t have a pension or still come up short after your pension, consider using an annuity to make up the difference.  

The key with the flooring method is that your fixed monthly expenses are covered with lifetime income that you can’t outlive and you can use the rest of your investments to help combat inflation.  

Periods of high inflation are generally temporary as the Federal Reserve works through their inflation fighting measures.  However, even when inflation falls back down, the impact on your portfolio shouldn’t be dismissed as inflation can and will erode some of your future purchasing power.  

Whether you tighten your expenses for a stretch during high inflation, reallocate your portfolio or use the flooring method to cover your fixed monthly expenses, be sure to stay on top of inflation’s effect on your budget and on your portfolio.

Content on this site is for reference and information purposes only. Do not rely solely on this content, as it is not a substitute for advice from a financial advisor or accounting professional. Aging.com assumes no liability for inaccuracies.

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