Inflation has been very tame in recent years and at historically low levels. This is in sharp contrast to the double-digit levels of inflation we saw at various times from 1974 through 1981.
High inflation can overheat the economy and can cause any number of problems. One segment of the population that is particularly hard hit by high inflation are retirees and anyone on a fixed income.
I am a firm believer that the main enemy of any retiree is inflation. This is a far greater risk to their ability to maintain their lifestyle and to make their nest egg last than market corrections.
Inflation and Purchasing Power
Using the “rule of 72,” here is the impact of 1% increase in inflation expressed as the length of time it would take to cut your purchasing power in half.
|Rate of Inflation||Years to Cut Purchasing Power in Half|
Since the end of World War II, the annual rate of inflation has averaged 3.8%, though it has been well below 2% in recent years. So a realistic rate of inflation of 3% would cut your purchasing power in half in 24 years. For someone aged 65, this means your spending power would drop by 50% around age 89, not an unrealistic life expectancy by today’s standards.
Social Security Cost of Living
Social Security recipients received no cost of living increase for 2016. According to the Social Security Administration, there was no increase in the Consumer Price Index for the benchmark period of the third quarter of 2014 through the third quarter of 2015.
Some have argued that using the CPI as the measure of inflation understates the real inflation seniors and retirees experience. For example, in the 2015 edition of Fidelity Investments’ annual study of the projected medical costs during retirement for a hypothetical couple both aged 65, the estimate was $245,000. The 2014 version had a projected cost of $220,000, an increase of 11.4% in one year. Clearly this is quite unscientific, but it does illustrate the problem.
Steps You Can Take to Mitigate the Impact of Inflation in Retirement
As far as the actual rate of inflation, there is of course virtually nothing any of us can do to control this. We can, however, take steps to insulate ourselves from the impact of inflation during retirement. Here are some steps you can take, depending upon your situation, to mitigate the impact of inflation on your retirement.
1. Fund a health savings account (HSA). For those of you who are still working and/or not yet on Medicare, funding an HSA account is a great way to help cover the costs of health care in retirement. In order to contribute to an HSA you must have a high-deductible health insurance policy either via your employer or privately.
The HSA allows you to make contributions to the account on a pre-tax basis and allows withdrawals tax free for qualified medical expenses, including premiums for Medicare and certain long-term care policies, in addition to more traditional medical and dental expenses.
The key to using your HSA as an additional retirement account is to cover out-of-pocket medical expenses while you are working from other sources and let the balance in the account continue to grow. For 2016 the HSA contribution limits are $3,350 for an individual and $6,750 for a family, with an additional $1,000 in either case for anyone 55 or older. In 2017 the contribution limit will increase by $50 for an individual, with the rest of this remaining unchanged.
Whether via an HSA or other means, it is critical that retirees plan for how they will cover the cost of health care in retirement.
2. Delay taking Social Security benefits. If you can afford to, it helps to delay claiming your Social Security benefits as long as you can. For example, if you begin claiming your benefit at age 62, the earliest you are eligible to do so, rather than waiting until age 66, full retirement age (FRA) for those who were born before 1955, your benefit will be reduced by 25%. For those born in 1960 or later, the FRA is 67, and waiting until then avoids a reduction of 30%.
Waiting to claim your benefits beyond your FRA results in an increase of 8% per year until you reach age 70, when your benefits will max out.
While waiting longer will not impact any cost-of-living increases once you commence taking your benefit, by waiting, your initial benefit will be higher, and this will be the basis for any future cost of living increases.
3. Invest to beat inflation. While your inclination might be to ramp down your allocation to stocks and other more aggressive investments at retirement, the reality is your investing time horizon is really your life expectancy. Years ago people would retire at 65, and their life expectancy was much shorter. Today it is not unusual to live into your 90s or longer. That’s a retirement period that might last as long as your working career.
Certainly nobody is advocating that someone in their 60s invest the same way as people in their 20s or 30s, but stocks are an important part of your retirement portfolio. Most people need to have some allocation to stocks in order to stay ahead of inflation and not see their spending power and their nest egg eroded.
Investments like TIPs (inflation-protected Treasuries), real estate investment trusts (REITs) and others can also be appropriate.
Bonds might also be an appropriate part of your portfolio; they have a low correlation to stocks and have historically provided downside protection during stock market corrections.
Overall you will want to ensure your returns beat inflation. Real returns are what is important. For example, if inflation is 3% and your investments earn 2%, your real return is –1%; you’ve lost ground to inflation.
4. Consider long-term care insurance. Those approaching retirement should consider purchasing long-term care insurance as one means to cover these costs in the event you or a spouse need this type of care. The coverage can be costly, but the cost of care can eat through your nest egg quickly if you haven’t made provisions to cover these costs. Many policies come with a rider that protects, at least in part, against inflation in these costs as well.
5. Have a plan for retirement account withdrawals. You will need to have a plan in place to manage the withdrawals from your retirement accounts in terms of which accounts and in what order. This serves two purposes. First, it helps you take withdrawals in the most efficient fashion, and second, it helps you minimize the tax impact of these withdrawals to the greatest extent possible. The latter, if done well, can result in substantial tax savings, and these savings will give you more spendable income, which is a great way to combat inflation.
Inflation is the biggest risk faced by retirees. The impact of protracted inflation is far more devastating to your retirement security than losses you might suffer on your investments during the inevitable market corrections that occur periodically. Your retirement planning needs to include steps to be sure you can stay ahead of inflation during retirement.