Ignore Inflation at Your Own Risk

Inflation can chip away at your retirement savings.

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Roger Wohlner
Inflation may seem like a non-existent threat in today’s economy. In fact, we are hearing about the possibility of deflation on some of the financial newscasts.

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While nobody can predict the future, it’s unlikely that inflation is dead. Some say that within a few years, the various economic stimulus measures currently being put into place will trigger the next round of inflation. When planning for retirement, ignoring the impact of inflation can prove to be disastrous.

An inflation rate of 2 percent or 3 percent per year, over a period of many years, can seriously erode the purchasing power of your funds. At 2.5 percent inflation, $1 today will be worth 78 cents in 10 years, 61 cents in 20 years, and 48 cents in 30 years. That can have a major impact on those entering retirement.

New retirees are less likely to have defined-benefit pensions. Thus, they must rely more on Social Security benefits and personal savings, including defined-contribution plans such as 401(k) plans.

Cost of living adjustments for Social Security benefits are less generous. While Social Security benefits are still adjusted for inflation based on the consumer price index (CPI), the methodology for calculating the CPI changed dramatically in 1999, thereby reducing increases in the CPI. Case in point, the first cost of living increase in two years was just announced. While one would think that no politician would risk tampering with Social Security benefits, the whole issue of reducing entitlements is a popular one today.

Retirees are living longer. As life expectancies increase, retirees are spending more years in retirement, so their retirement savings are subject to the impact of inflation over a longer time period. Today, it is not uncommon for people to be retired for as many years as they spent in the workforce.

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Healthcare costs are becoming more of a burden to retirees. More and more companies are reducing benefits or eliminating healthcare insurance for retirees, and healthcare costs have tended to increase faster than overall inflation. The impact healthcare reform legislation is also a wildcard here, as nobody is certain of the impact on retirees, if any.

To combat the effects of inflation on your retirement income, consider these tips:

Use a conservative inflation rate for planning purposes. Since your retirement is likely to span decades, consider inflation over long time periods. For instance, while inflation has averaged 2.54 percent over the past 10 years, it has averaged 4.31 percent over the past 30 years (Source: Bureau of Labor Statistics, 2007).

Consider investment alternatives likely to stay ahead of inflation. While it is tempting to avoid stocks, especially in this volatile market, stocks have typically earned returns in excess of inflation over longer periods of time. Your investments should be diversified among various vehicles based upon your risk tolerance, your income needs, your age, etc.

Invest in tax-advantaged investment vehicles. Look into 401(k) plans, individual retirement accounts, and other retirement vehicles. While each has different rules for taxing contributions and earnings, all provide some tax-free or tax-deferred benefits. Since you aren't paying income taxes on earnings throughout the years, that typically means you'll have a larger balance at retirement than if you were paying taxes throughout the years. Thus, you'll start out with a larger retirement base to help combat inflation's effects. A note of caution here: Tax rates are currently at historically low levels. Future rate increases might serve to take a larger bite out of your retirement plan distributions. For this reason, a mix of tax-deferred, taxable, and Roth accounts might offer greater flexibility in tax and withdrawal planning in retirement.

Keep fixed expenses as low as possible. Try to enter retirement with as few debts as possible. If you aren't using a significant portion of your income to pay a mortgage, car payment, or credit card debts, you'll have more flexibility to deal with higher prices.

Decide how you will deal with healthcare costs. While Medicare will help once you turn age 65, it still does not cover many healthcare costs. Look into Medigap policies and prescription coverage to help with those non-covered expenditures, especially if your employer does not provide health insurance after retirement.

Minimize withdrawals from your retirement assets, especially during the early years of retirement. To counter inflation, you need to withdraw larger and larger sums just to maintain the same purchasing power. To make sure you don't run out of funds late in life, keep withdrawals during the early years to a minimum. Conventional wisdom in the financial planning world says that 3-4 percent can generally be withdrawn each year. This is a guide at best. The reality is that you will need to manage and potentially adjust your annual withdrawals based upon factors such as inflation and investment returns.

Be prepared for change. After retirement, keep a close eye on your investments. If inflation increases and you are concerned that increasing withdrawals may deplete your investments, you may want to look for ways to reduce your living expenses or go back to work at least part-time.

Inflation is down, but in my opinion, not out. Even low levels of inflation can erode the purchasing power of retirees over time. Failing to plan for inflation in retirement is a plan for failure.

Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. He recently cofounded Retirement Fiduciary Advisors to provide direct investment and retirement planning advice to 401(k) plan participants. Follow Roger on Twitter and LinkedIn. Roger also blogs at Chicago Financial Planner.