Inflation is an annoyance that hits us all in the wallet every time we stop at the supermarket or gas up our vehicles. But that's the short-term impact. As you look forward to retirement, it's important to consider the long-term effects of inflation on your future financial well-being.
The inflation rateaffects how much your retirementsavingswill really be worth years from now. Over time, it can seriously devalue your savings and reduce your income. Factoring inflation into your retirement strategy is key to a workable financial plan for the future.
Key Takeaways
- The balance in retirement savings accounts like IRAs and 401(k)s can get hit by inflation if the money isn't invested in assets that will at least match the inflation rate.
- If you have a pension, it may or may not adjust for inflation but it's debatable whether the increases have been sufficient.
- Social Security benefits are adjusted for inflation every year.
- Inflation has a direct impact on the revenue, savings, and spending of all consumers, including retirees.
- Interest, dividends, and rental income all tend to move with inflation. Check occasionally to make sure you're still getting a good deal.
- Put cash to work. Conservative investments will get you a better return that a regular savings account.
- Retirees can diversify their revenue streams, allocate their savings wisely, and make mindful spending choices to protect against rising costs.
Retiree Sources of Income
You probably anticipate having more than one source of income during retirement. The mix could include Social Security income, savings, investment income, and pay for part-time work. Not all sources of income are the same in terms of their vulnerability to inflation.
Social Security
Approximately 92% of all Americans age 65 and older in the United States claim Social Security benefits.
Every year, Social Security benefits are evaluated against inflation indexes to calculate a cost of living adjustment. The adjustment has been as low as 0% in 2015 and as high as 8.7% in 2022.
Historically, the cost of living adjustments have been seen as inadequate; The Senior Citizens League estimates that Social Security Benefits lost one-third of their purchasing power between the years 2000 and 2021.
Between January 2000 and January 2020, Social Security benefits increased 53%. A study by The Senior Citizens League estimates the cost of goods and services typically purchased by retirees increased 99.3% during the same period.
Pensions and Retirement Plan Withdrawals
If you've been contributing to a retirement savings plan like a 401(k) or an IRA for all of these years, retirement is the time you'll start withdrawing the money.
If you're lucky enough to have a pension, that will start to pay off. In the private sector, pensions have largely been phased out and replaced by savings plans like the 401(k). Most employees in the public sector are still covered by pension plans, and they remain in place in a few private industries like transportation and entertainment.
In either case, this is where you really have to consider the effects of inflation on your retirement income.
Retirement Plans and Inflation
The only remedy to inflation in retirement is to save early and often if you can.
Saving early means contributing to your 401(k) or to an IRA right from the start of your working career to take full advantage of the magic of compound interest.
Saving often means taking full advantage of the annual maximums for tax-advantaged retirement plans.
You might also consider putting your retirement savings into a Roth account rather than a traditional account. That means paying the income taxes due in the same year you make the contributions. It's a little more pain in the present for a great deal of gain in the future. As a retiree, you should owe no additional taxes on that money.
Pensions and Inflation
Pension plan benefits are usually tied to the last several years' salary rates earned by the employee. If a period of high inflation hits during the last year or two of a retiree's career, their benefit amounts may come in lower as they are partially based on pre-inflation salary figures. If inflation occurs after the person retires, their payments will be based on a salary that does not reflect the current market rate.
In addition, your benefits may or may not be adjusted for inflation. The National Association of State Retirement Administrators estimates that 75% of pension plans sponsored by state or local governments provide some coverage of cost of living adjustments. Private pension plans often do not.
Interest, Dividends, or Rental Income
Passive forms of income such as interest, dividends, and rental income usually move in the same direction as inflation, although they might not equal it. About 46% of retirees collect at least one of these three income sources.
Interest rates usually rise when the Federal Reserve implements increases to the federal funds rate.
Dividends are stock investors' share of the profits. Whether the investors get a dividend and how much is decided by a company's board of directors based on the company's latest financial results.
When the Federal Reserve raises the lending rate, it's doing so to cool off the economy and control inflation. When the economy slows, some companies inevitably generate lower earnings and may have less cash available for dividends.
Rental income, on the other hand, is often a strong income source during higher periods of inflation. If leases are locked into terms no greater than one year, landlords can raise rent to account for inflation at the end of the lease term.
Wages, Salaries, or Self-Employment Income
Many retirees choose to pick up a part-time job or a side gig. One-quarter of all retirees generate this type of income.
Broadly speaking, there is no mandated cost of living adjustment for salaries or wages. Companies set policies on their own and decide what, if any, adjustments to make.
Government entities often are forced to evaluate their payroll costs due to regulations.
In 2022, all active federal workers received a 2.7% pay raise, while retired federal government employees received an additional cost of living adjustment depending on which retirement system covered them.
Cash and Savings
After a long, successful career, some retirees may find themselves with a large investment balance or high cash savings.
While it's great to have money on hand, retirees risk seeing their cash pile shrink due to inflation. Consider that a dollar in 1983 would buy 37 cents worth of goods and services in 2021.
If you have a lot of money languishing in savings accounts, you might consider Triple AAA-rated bonds or similar conservative investments that offer a better return for just a little more risk. Your goal is to keep up with inflation.
How Inflation Affects Retiree Budgets
The primary concernfor retirees ishow inflation affects their purchasing power. This is true even if inflation remains low.
Once you retire, some expenses will shrink or disappear and others may grow. The Center for Retirement Research at Boston College found retirees tend to consume less than when they were working, though this is heavily dependent on their income levels and state of health.
Retirees may wish to travel more. Prices for leisure travel, although highly susceptible to economic swings, tend to go up over time. For example, airfares, which are a component of the Consumer Price Index, have been climbing steadily since at least 1990, except for a precipitous drop during the COVID-19 pandemic.
Housing Costs
Among the big decisions retirees face is whether to sell their home and enjoy the flexibility of becoming renters again, downsize, or stay in place.
Should retirees decide to rent, they must be mindful of escalating rent costs. Average asking prices for rentals soared by as much as 18% nationwide after the COVID-19 pandemic. Notably, the warm-weather cities favored by many retirees were among the worst hit. By the end of 2023, the price increases were leveling off, at least for the short-term.
Last, a survey from the Employee Benefits Research Institute found that 45.9% of retirees spent more in the first two years after they retired than they did in the years immediately prior. Twenty-eight percent of households were spending 120% of their pre-retirement income over that same period, which suggests that some seniorsmay be experiencing lifestyle inflation.With more time on their hands, retirees may be tempted to spend more.
Downsizing to a more affordable apartment or house can help seniors save money over time. Retirees who purchase a home for less than they sell their current home for can improve their living situations and still avoid renting.
What Retirees Can Do to Curb Inflation’s Side Effects
While retirees can't directly stop inflation there are ways to minimize the shadow it casts.
- Reduce housing costs. Trading in a large home for a smaller one reduces the monthly outflow for property taxes, utilities, homeowners insurance, and maintenance. Retirees worried about future inflation may want to steer clear of renting.
- Add inflation-correlated investments to your portfolio. Some investments do better when inflation is high. Consider rebalancing your portfolio to include inflation-proof stocks or higher-interest bonds.
- Diversify income streams. Some income streams increase due to inflation; others go stagnant. Consider moving away from fixed-income sources of income and into sources of income that adjust with inflation.
- Calculate your retirement needs as early as possible. By saving early in your working career and factoring inflation into what you will need, you'll be better prepared to leave the workplace behind.
Retirees may be tempted to shift into riskier investments. Consider consulting a financial advisor about the proper level of risk for your goals.
Does Social Security Increase With Inflation?
Sort of. The federal government reviews the consumer price indexes once a year and determines whether to adjust payments and by how much.
One complaint about the process is that it doesn't zero in on inflation in goods and services that retirees rely on more than most, such as prescription drug prices and healthcare costs.
In any case, it's unwise to rely on Social Security alone. Your benefit is largely based on your best earning years before retiring. No matter how good that was at the time, it may not look like much 20 years later, even with inflation adjustments.
What Will Inflation Do to My 401(k)?
Inflation has a complicated correlation with your 401(k) balance, and it largely depends on the assets you're holding. Inflation causes company revenue to increase, but it also can escalate costs to manufacture, distribute, and market products.
Your 401(k) balance is more likely to take a hit when the government acts against inflation by raising interest rates. Bond prices fall, companies find it more expensive to raise debt, and real estate leases turn unfavorable when locked into long-term leases.
On the other hand, commodity prices can rise along with inflation, and some government bonds are pegged to inflation rates. There are ways to shield your 401(k) against inflation.
What Should I Do With My Money During Inflation?
This question is best posed to a financial advisor who will review your specific situation.
Many will suggest considering Treasury Inflation-Protected Securities or short-term bonds. Some may recommend real estate investment trusts tied to short-term leases. Others may suggest alternative assets that have a positive correlation to inflation, such as gold or commodities.
Be mindful that any decision you make to protect against inflation may work against other priorities for your portfolio. The mix is important.
The Bottom Line
Inflation can be a retirement killer, but it doesn't have to be if you take the time to develop a plan for beating it. Creating a realistic retirement budget, adjusting asset allocations, and being ready to adjust your revenue streams can all help to soften the blow.
