Inflation Risk for Retirees

Many people underestimate or even entirely leave out the impact inflation has over time. Today we want to discuss the risk of inflation and some ways to address this risk in your financial plan and budget.

Zachary R. Mersberger, CFA®, CRPC, AIF®

Oct. 5th, 2016

A group of hot air balloons
A group of hot air balloons
Inflation Risk for Retirees

As our clients get closer to retirement and eventually do retire, one of the areas we spend a lot of time in is the financial plan. This is essentially the roadmap that lets our clients see whether retirement is feasible, what type of retirement income they might expect, and what they need to do to stay on track towards achieving their goals. An essential part of this process is determining what our client’s budgets will be in retirement. A very common mistake many people make is that once they have established a budget they assume that budget will remain static for their retirement years without changing over time. While it is impossible to predict how one’s budget will change over time, there is one factor that we know with certainty will affect the budget. That factor is inflation or the change in the cost of living over time.

Average Inflation

Since the year 2000, inflation has averaged roughly 2.50% per year. That means that every year on average, prices have increased by 2.50%. While this doesn’t sound that serious at first, this means that on average prices will double approximately every 29 years. So if someone retires at age 60 and expects to live until age 90, their budget will have to roughly double over that time period just to keep up with the cost of living. While this may sound crazy, think about the prices of some common goods such as gas, bread, milk, etc. and how much they have increased over time…that is a perfect example of inflation. Since life expectancies are only increasing, we see it as critical to plan for inflation and the fact that budgets will need to be increased over time in order to keep up with the cost of living.

So how can you make sure you are addressing the problem of inflation?

Today, we are going to give you three simple ways.

Financial Plan

First, a great thing everyone can do is look at a financial plan as early as possible. This way, if you are not on track to meet your savings/retirement goals, you have time to get back on track.

Review Your Investment Portfolio

Examine your investment portfolio. If possible, your conservatively allocated assets should be beating the inflation rate. If you have a large number of assets in bank accounts or short-term CDs we know that this is not happening (with current interest rates being offered by banks) and you are essentially losing money to inflation every year. Some good substitutes for CDs would be short-term bonds (government, corporate, or municipal), however, these may carry additional risks so you should be aware of those risks and discuss them with your advisor before making any decisions.

Long-Term Growth Investments

Last, you should examine whether it is appropriate for your portfolio to have a portion allocated to long-term growth-oriented investments (an example would be stocks). While you historically have experienced more volatility and risk with these assets, you have also historically experienced higher returns. Higher returns are one of the best ways to offset inflation. If you do have some long-term growth investments in your portfolio, it is best to ensure that you have other, additional assets that are more conservative that you can draw income from now. That way, you are not as affected by the volatility in the growth assets and these assets can be used for income later on in your financial plan. As these assets have historically experienced higher long-term rates of return, you may be able to offset the impact of inflation by eventually using the additional growth from these assets to supplement your income and budget.

Please contact our office if you have any questions regarding this topic.

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