Many people are concerned about inflation, as prices for goods and services continue to rise. For those nearing retirement, this can be a major concern because the cost of living may increase more than their income does. However, if you have a plan in place, you should be able to maintain your standard of living even as prices go up. This blog will discuss some tips on how to prepare for inflation.
Inflation can be a problem if it's high enough to cause your spending to increase, which might lead to bankruptcy or other financial problems. Even low levels of inflation can affect how much money you'll have available in retirement and when you can start investing for the future.
Getting to Know Inflation
The Bureau of Labor Statistics releases a report called the Consumer Price Index (CPI) to track fluctuations in the average level of prices. Based on the index level which was set in 1984 at an even 100, the CPI has risen nearly every year. This index is based on detailed information provided by families and individuals on purchases made in the following categories: food and beverages, housing, clothing, transportation, medical care, recreation, education and communication.
What does this have to do with inflation? Everything, since inflation is a general increase in prices. It can be caused by many factors, including economic conditions and changes in the money supply. The rate that the CPI rises considering the cost of goods and services is the inflation rate. In the last year, the CPI has increased, giving an annual inflation rate of 7.9%. However, there are a few things you can do to be ready for inflation.
How to prepare for inflation:
- Be aware of how the CPI is calculated and what it measures.
- Make sure that your investments are indexed for inflation.
- Keep an eye on your spending and make adjustments as needed so that you're not overspending in an attempt to keep up with inflation.
- Have a plan for when inflation becomes a problem and take steps to address it.
Why Inflation Matters in the Long-Term
Now let's get into the specifics of inflation in your financial planning. When you retire, your expenses will be different than when you were working. For example, your salary may not have kept up with inflation, so some of the costs associated with retirement (like healthcare) will increase.
To protect yourself in retirement, you'll need to create an income plan that anticipates inflation and allows you to adjust for inflation spikes. To do this, look at where your income comes from. Do you have stock dividends? Will you have a large amount of Social Security benefits? These two sources of income work relatively well with long-term inflation. The vulnerability comes in with fixed income. For example, annuity and interest payments have a fixed rate of return which does not combat inflation for long-term planning. However, there are options for both that include inflation protection. Figuring out which sources of income are dominating your budget is essential to anticipating how inflation will affect your savings.
Risks in retirement planning
- Longevity Risk. Social Security, pension income and annuity payments provide a guaranteed income for life. You should be smart about when and how to claim your Social Security benefit in order to maximize it.
- Market Risk. Reducing your exposure to stock and bond markets will reduce your risk and reward associated with investing, making it easier to achieve long-term financial goals.
- Inflation Risk. To ensure that you have enough money in retirement, you should plan for a lower income at the start of your retirement. This can be done by accepting a lower salary initially, or by building in a margin for inflation risk into your overall income.
Managing Inflation with Investments
Planning for retirement isn't just about making sure that you have enough money saved; it's also about having a plan for when you no longer have a job and need to rely on income from your investments. Typically, the value of your investments will increase along with inflation, so there's a chance this could be an additional source of income during retirement. Of course, it's important to have a diversified portfolio, so you're not too reliant on any one type of investment.
In order to do this, you have to account for inflation early on. One way is to use an inflation-adjusted measure of return. This takes into account the fact that stocks and bonds will provide a lower return over time as prices increase. Another way to account for inflation is to use a nominal dollar value. This measures how much money you would have if the current dollar value of your investments remained the same as when you made them.
The effect of the real rate of return
Additionally, keep in mind that there may be a reduced real rate of return, your purchasing power may decline, and the Federal Reserve has the ability to reduce the amount of money in circulation in order to control inflation. These three effects can have a significant impact on your retirement planning, so it's important to consider when adjusting your budget and investment planning.
Specifically, the real rate of return displays the effects of inflation on an investment's purchasing power. This occurs when inflation increases and the value of an investment decreases. To combat this, you may choose to hold onto investments for a longer period of time in order to maintain purchasing power. This can be a major factor if you're trying to save for retirement.
Managing Inflation in Real Time
No matter what percentage you choose for your inflation plan, it's important to realize that any short-term inflation rate won't match your assumption. There are multiple ways to adjust to this short-term inflation, so you can still achieve your goals. Here are a few suggestions:
- When prices for goods increase temporarily, it may be best to defer purchases until the price drop occurs. This will help avoid having to pay more than necessary for the item.
- If deferring purchases isn’t an option, use your liquid savings accounts to purchase the items. Avoid drawing down from your retirement savings.
- If you anticipate that prices will continue to increase, it may be wise to revise your inflation assumption and create a new plan. Make sure to monitor your plan on a regular basis in order to stay updated.
It all comes back to a trusted financial professional...
A fiduciary financial advisor can help you better understand the market and develop an investment strategy to protect your money from potential losses. If you're not sure what kind of investment to make, or if you'd like help building an investment plan that takes both possible scenarios into account, contact your investment management advisors today.
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