Inflation Diminishes Purchasing Power Over Time
Inflation causes the gradual rise in prices and the slow decline in the purchasing power of our money over time. For example, if the annual inflation rate is 3% per year, a $1 apple today will cost $1.03 next year. As we apply a 3% inflation rate more broadly, we see a household spending $70,000 this year will need $72,100 next year to have the same purchasing power. After ten years at this inflation rate the household needs $94,000 to retain the same purchasing power of their $70,000 today. Future retirees must factor in inflation risk to their plans in order to protect the purchasing power of their retirement income.
In Retirement You Are Responsible for Inflation Risk
The reason some new retirees are unprepared for inflation risk is because they did not see its impact while working. Most employers factor in inflation as part of labor costs and offer employees an annual cost of living increase to mitigate the effect of inflation. These 1-3% salary increases each year keep employees at or slightly ahead of where they were financially the previous year. However, in retirement you are responsible for this risk and need to ensure your income keeps up with inflation. Keep in mind that inflation rates can rise dramatically which can be scary for retirees.
Double Digit Inflation Happens
Average annual inflation in the United States between 1913 and 2019 was 3.10%. However, this was not a smooth progression and there were periods where inflation spiked. During the 1970s there were years when inflation was 5% or 6% and in the middle of the decade it hit double digits. If inflation were 10%, a household spending $70,000 would need $77,000 the following year and possibly $84,700 the year after just to have the same purchasing power. Inflation also does not apply equally to all goods and services. The long term average of the U.S. health care inflation rate is 5.25% and the average inflation rate for college tuition is about 8% per year. This means the cost of a college education doubles about every nine years. Plan for higher inflation rates for these types of expenses if they will be funded from your retirement income.
Inflation’s Impact on the Economy
To provide stability the Federal Reserve uses monetary policy, controlling the supply of money in the economy, in an attempt to keep inflation at a rate of 2%. If inflation is stable, the economy overall is more stable and less likely to face periods of asset bubbles followed by rapid declines in asset prices. However, there is only so much the government can do to control inflation; we have seen periods of high inflation and we will again in the future.
As inflation rose dramatically in the 1970s it spread through the economy. In 1981 the 30-year fixed mortgage rates rose to an all-time high of 18.63%. Compare that to the below 5% mortgage rates we have seen for the last decade. This high inflation also brought on two recessions in close succession in the early 1980s with unemployment nearing 11%. Prices went up sharply, loans became more expensive, and people lost their jobs. In this type of situation, you will find yourself in financial trouble if your annual retirement income remains static.
Managing Inflation Risk
The way to mitigate inflation risk is to diversify your investments into assets with higher rates of return to generate enough retirement income. For example, if you have $1 million invested in U.S. Treasuries that are paying a rate of 2.5% you will be earning $25,000 a year. Even though this is a sizable nest egg it is invested too conservatively, and the returns are not enough to cover living expenses or to provide protection from inflation risk. Being too cautious with your investments can be as bad as being too risky.
Diversifying an Investment Portfolio Against Inflation Risk
An investment portfolio should include some investments in real estate and broad index funds of stocks which generate higher returns over the long term. Stocks offer dividend income and the benefit of appreciation. The S&P Index of 500 companies has earned an average return of about 10% over the last century. If the $1 million portfolio above was invested in 60% stocks and 40% bonds the account holder could expect to withdraw $40,000 in the first year and increase their annual withdrawals to match inflation rates of 2-3% in future years without running out of money.
Similarly, rental properties also offer the benefit of monthly rents which should rise over time to generate income that keeps pace with inflation. Real estate also tends to appreciate which means these assets will be worth more in the decades to come which is another hedge against inflation. Holding a smaller portion of conservative assets like U.S. Treasuries or certificates of deposit is appropriate for six months worth of expenses but holding more than that could deprive your portfolio of the asset allocation required to hedge against inflation risk.