Inflation is a common term, but not everyone understands what it means or how it affects finances. Simply put, inflation refers to when the prices of goods and services rise, meaning that each dollar is not as valuable. The average rate of inflation has recently ranged between 1-5% annually. That doesn’t sound like much from one year to the next, but it makes a big difference over the course of decades.
When planning for retirement, you need to keep inflation in mind. Something that costs $5 today will cost more in 5, 10, 20, or 30 years from now. Having an understanding of inflation and how it affects retirement funds will help ensure that you save enough.
Examples of How Much Retirees Stand to Lose to Inflation
When looking at the money you have available for retirement, you can’t view the sum in relation to what things cost today. You may feel like you have a good nest egg, but in reality, it will not be worth as much by the time you retire. A study conducted by LIMRA looked at how inflation affects Social Security payments over the course of 20 years. When inflation stays steady at 1%, a retiree essentially loses more than $34,000 in benefits. Likewise, an inflation rate of 3% results in a loss of over $117,000.
This study only looks at Social Security benefits that the average retiree receives after retirement. Inflation will also affect any other retirement funds that you have, such as 401(k) accounts, IRAs, stocks, and other investments.
Reasons to Be Concerned About Inflation and Your Retirement
With inflation, as the price of goods and services increase, the value of a dollar is diminished. This is a concern for retirees because their purchasing power is lower. Ideally, inflation will stay low year after year, but it will always exist.
When it comes to retired people, the rising cost of health care is a big problem. The most recent data available shows that inflation was 2.4%, while the cost of health care increased by 4.6%, far outpacing inflation. As people age, they normally develop more health problems, so retirees typically spend three times as much on health care as working adults and five times more than children.
Between annual inflation and quickly rising health care costs, it is essential to factor in these issues when planning for retirement. Use an accurate retirement planning software package to help you figure out what rising inflation might do to your retirement plan. Software such as WealthTrace and eMoney are very details planning applications where you can actually run scenarios that show you what various rates of inflation can do to your retirement plan. WealthTrace is built mainly for consumers, while eMoney is built mainly for advisors.
It is important to note that the Social Security Administration does not increase monthly benefits based on consumer prices. They tie their increases to the CPI-W, which is a wage growth index. This index has lagged behind the change in consumer prices for many years now. This means that you will have to plan accordingly to ensure that your other investments can keep up with inflation when you retire.
Retirement should be an enjoyable time after decades of hard work. But, a number of new retirees end up spending a lot more than they did in the years immediately before retirement. It is important to consider what type of lifestyle you want when you retire so you can plan accordingly. You will need to factor in inflation when determining how much money you need to live each month comfortably.
Tips to Lessen the Side Effects of Inflation During Retirement
No individual can control inflation rates, but there are things that someone nearing retirement can do to offset the effects. One simple solution that can have a positive impact is to reduce housing costs. Downsizing to a smaller home will lower the cost of utilities, property taxes, and homeowners insurance. A smaller home is also less expensive to maintain.
Investing properly can also help lessen the side effects of inflation during retirement. Some investments are better at keeping up with inflation or even outplacement it. Historically, investing in a real estate investment trust (REIT) or energy sector stocks is a good investment when you want to increase your wealth without inflation eating away at your profits.
There is sometimes not a lot you can do about inflation, whether you are retiring five years or 25 years from now. As time moves forward, prices will increase, and the dollar will not have the same buying power that it has today. However, there are things that you can do so you can still retire comfortably, despite inflation. Making targeted investments that keep up with inflation, taking the time to establish a retirement budget, and reducing expenses can make a big difference.