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What Does Inflation Mean for Your Retirement

Imagine that you’re retired, living on a fixed income, and your energy bill has just gone up by 11 percent. On top of that, your gas tank now costs 50 percent more to fill up, and groceries cost 5 percent more than usual.

That might sound crazy, but this is exactly what’s happened over the past year. According to the U.S. Bureau of Labor and Statistics, the consumer price index (CPI) for all items has risen by 6.2 percent when compared to prices from 12 months ago.

Inflation is a fact of life. However, higher-than-typical inflation can potentially have a negative impact on your retirement plans and force you to make uncomfortable decisions. If you are watching the recent inflation reports with some concern, here’s what you need to know.

How Does Inflation Affect Retirement Planning?

It’s easy to think that those who are “really” prepared for retirement have nothing to worry about. It’s also easy to think that there is no way you can ever be prepared, and that monitoring inflation has no benefit. No matter where you fall on that spectrum, it’s important to pay attention to inflation. Here’s why.

Inflation Reduces Your Purchasing Power

Inflation causes prices to go up. And more than likely, some of those prices may represent expenses that you cannot simply cut out of your budget.

Take, for instance, necessities such as food, shelter, medical care, transportation, and heat. When you are retired, if each of these expenses goes up by just 5 to 10 percent, that’s going to take a noticeable bite out of your budget.

It may be possible to use less of some of those necessities, but most people can’t eliminate them completely. So, how will you make it work? You may be forced to sacrifice some of the small luxuries you enjoy, such as traveling or playing golf. Or in more severe cases, you may even need to consider going back to work part-time to supplement your retirement.

Your Nest Egg Target Might Need to Be Larger

With reduced purchasing power due to inflation, your target nest egg amount may no longer be enough.

Here’s one example.

Let’s say you have previously determined your living expenses during retirement should be about $60,000 per year. You could roughly estimate that your nest egg target should be around $1,500,000. However, rising inflation may have you reconsidering that your living expenses could actually be closer to $75,000. In that case, your new nest egg target would be $1,875,000.

That creates a difference of $375,000 which translates into more that you’ll have to save!

Withdrawal Rate Might Need to Be Greater

If you’re already retired and inflation is forcing you to take out too much money from your nest egg, it could potentially cause you to run out of money.

There’s an old rule of thumb that recommended retirees should take no more than 4 percent from their portfolio annually. While this 4 percent figure may not necessarily be the right number for everyone, virtually everyone who is planning a retirement will have some optimal rate at which withdrawals cover their expenses without compromising financial security. The bottom line is that the more you exceed your optimal number, the greater are your chances of potentially depleting your nest egg if there is a variance in expected inflation.

How to Factor Inflation into Retirement

Accounting for inflation in retirement planning is not as difficult as you might think. Here are a few strategies you can easily implement as part of your plan.

Always Think About Investments in Real Returns

If you’ve ever used an online calculator to estimate how much your nest egg will grow in the future, then it’s important to use real returns instead of nominal returns.

What’s the difference?

Nominal returns are not inflation-adjusted. When someone says, “the market returned 10 percent last year,” this is the nominal return.

To get the real return, you need to subtract the inflation rate from the nominal return. For example, if inflation happened to be 4 percent last year, then the real return was actually 10 – 4 = 6 percent.

Using the real return will give you a more realistic idea of what your nest egg will be worth in the future. For instance, consider someone who’s saving $500 per month over the next 30 years.

  • Using the nominal rate of 10 percent, they might expect their savings will grow to $986,964.
  • However, using a real return of 6 percent, they’d find their nest egg would only be able to buy about $474,349 worth of goods in today’s dollars. If that’s not enough, then they could use this information to bump up their savings rate.

But that only scratches the surface.

If you really wanted accuracy, you would involve a certified financial planner who would work to further define the real return by factoring in your taxes and apply other factors to create your specific plan. While this would lower your estimated future savings, the end result would be more realistic.

Revisit Your Investment Strategy

Fixed-rate investments like savings accounts, CDs, fixed annuities, etc., are often used in retirement planning to offer a measure of stability to your nest egg. However, with interest rates low, you must watch for situations where your nominal return may not be keeping pace with inflation.

To give your savings a chance to grow beyond the rate of inflation, a portion of your portfolio may need to balance other investments, such as stocks, mutual funds, ETFs, REITs, etc. Your mix or “asset allocation” will be highly dependent on your resources, goals, and needs — as well as your ability and willingness to take on risk. Be sure to work with a financial advisor to determine the right portfolio for you.

Maximize Your Savings by Minimizing Taxes

At the end of the day, you may not have any control over inflation. But you can potentially offset it by having a smart tax strategy in place that will reduce what you owe to the IRS.

Roth IRAs, Health Savings Accounts and Charitable Bunching are some strategies a financial advisor can utilize to reduce your tax bill and leave more in your portfolio for potential growth.

If you want to explore this and other tax planning strategies for retirement, be sure to register for our free webinar, “The Road to a Tax-Savvy Retirement.” It is a great way to learn about our thinking on retirement planning, taxes, and some of the strategies that clients may consider to potentially lower their lifetime tax bill.

You can learn more and register here.

Remember, the less you have to pay to the government, the more you get to keep. Join us to learn how to avoid common mistakes and plan for a peaceful, secure retirement — even in the midst of inflation uncertainty.

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