You can’t afford to ignore inflation. If you stick your head in the sand on this one, you’re basically sabotaging your own nest egg.
Remember hearing about the era when grandma paid 20 cents to see a movie? Think back to your own childhood. How much did an afternoon at the movies cost when you were 10? A lot less than it does now! That’s inflation.
More technically speaking, inflation refers to the rate at which the prices of goods and services rise. Different goods and services experience rising costs at different rates, so we typically hear about the average inflation rate. The consumer price index may be the most common general measure of average inflation.
The reason all this matters to you and your retirement savings is that inflation can eat away at your money from two directions:
1. Inflation erodes savings. Inflation doesn't literally reduce the number of dollars you possess, but it does reduce your purchasing power. The interest rate your savings account is paying is likely well below the rate of inflation, which means that the cost of goods and services is climbing much faster than the value of each dollar in that savings account.
For example, assume your annual budget for 2013 requires a net total income of $50,000. You can expect that purchasing exactly the same goods and services in 2018 will cost more with inflation. That’s why many employers periodically offer cost-of-living raises to help you keep up. Unfortunately, your savings account doesn't get a comparable raise. On average, each dollar you own loses purchasing power and thus value every year.
2. Inflation depletes budgets. During retirement, when you’re no longer a full-time wage earner, budgeting becomes especially important. To help increase the likelihood that your savings will last through retirement, you’ll have to establish a budget.
The problem is that – as stated above – $50,000 per year in 2018 is expected to buy fewer goods and services than it did in 2013. And in 2023, $50,000 will probably buy even fewer goods and services than it did in 2018. You get the picture. You can’t plan to spend the exact same amount of money year after year and continue to meet your needs in exactly the same way. So as a retiree, you’ll need to give your budget a cost-of-living adjustment every couple of years in order to continue buying the same goods and services.
You’ll need to be especially aware of inflation in a few areas:
Medical costs are on the rise, and they’re significantly outpacing CPI inflation averages. In retirement, you’re likely to need more medical care than you do at a younger age, so carefully consider medical inflation as you plan for retirement.
Food costs can be volatile. For example, dairy, beef and grains have seen pricing spikes in recent years due to factors such as drought, livestock illnesses and changing farming practices. Expect more of the same in the future.
Fuel costs, like the price of gas, tend to affect most goods since shipping prices increase with fuel prices. As shipping costs rise, so do costs for goods that are shipped. And if you plan to travel in retirement, you’ll also feel the impact of fuel inflation on how much it will cost you to fly or drive.
What can you do to fight inflation during retirement?
First, as you calculate your retirement needs, you must incorporate inflation into your planning. You can find a variety of online calculators to help you do this, or else consult a financial professional.
Second, remain invested even during retirement. While you should gradually move to a more conservative portfolio as you approach and enter retirement, it’s important to sele ct a mix of investments likely to keep pace with inflation. Bonds, money market funds, and bank savings accounts alone, which are generally considered relatively safe places to put your money, may not provide enough growth to outpace inflation. Consider incorporating stocks and other investment types, as well, to add a prudent level of growth potential to your portfolio.
Scott Holsopple is the president of Smart401k, offering easy-to-use, cost-effective 401(k) advice and solutions for the everyday investor. His advice has been featured on various news outlets, including FOX Business, USA Today and The Wall Street Journal.