As you plan how much money you'll need in retirement, it's critical to consider inflation in your calculations. Inflation increases the costs of goods and services in the economy and effectively acts as an annual reduction in your investment returns.
Since the early 1990s, the inflation rate has averaged around 2.5% per year, though it's been just below 2% since 2009. That means if you earned a 10% return on your investments last year, your real return only amounted to 8% in comparable currency.
Thankfully, you can plan ahead for this by choosing certain types of investments and including a minimum cost-of-living adjustment in your calculations around investment returns and living expenses. Doing so can help keep your retirement savings right-sized for your financial needs each year without worry.
What Is Inflation?
Inflation is the increase in prices of goods and services between two points in time. A common measure of inflation is the Consumer Price Index, or CPI. This measures the costs of a basket of common household goods over time to show how prices have changed. But inflation doesn't just apply to goods you buy in a grocery store — it also affects your savings.
Most years see positive inflation, which means a dollar no longer goes as far. As a result, any money in your retirement accounts will need to grow at least as fast as inflation to retain its full value.
How Does Inflation Rate Affect Retirement Savings?
When you're on a fixed income in retirement, inflation can act as a gradual erosion of your purchasing power and retirement savings. You will therefore need to account for how inflation will counteract some of your investment returns over time.
Let's look at an example of how inflation can impact retirement savings. If you save $5,000 per year for 30 years and assume a 7% return each year, you'd have $510,365. This amount of money would go a long way toward paying for your expenses in retirement, though it might not be as much as you think once you consider the impact of inflation.
If we assume inflation averages 2% per year over the same period, $1 today will become worth a bit less than $0.55 in 30 years. Suddenly, that $510,365 becomes equivalent to $278,396 in inflation-adjusted dollars today. As a result, your savings money would be able to purchase less at a later time than it would now due to inflation. Accordingly, the retirement income you receive will need to grow more to keep up with inflation.
Social Security benefits and pension incomes receive periodic cost-of-living adjustments (COLAs) to account for inflation. For Social Security, recent changes in calculating these COLAs might weight certain expenses differently, causing the adjustments not to keep pace with the inflation that many people see in retirement.
In other words, the prices of goods and services you'll need in retirement will continue to increase each year, and you'll still need to meet these future prices with your retirement income and savings.
How Can You Mitigate Inflation in Retirement Planning?
Because inflation can diminish your purchasing power and the value of your retirement savings, you will need to keep it in mind as you pick your investments for retirement.
Investments in bonds, certificates of deposit or savings accounts often don't keep pace with inflation and may cause you to miss out on the appreciation you need. Stocks, on the other hand, are one of the few types of investments that can outpace the inflation rate over long periods of time.
You'll therefore want to save consistently, have exposure to a diversified portfolio of stocks for many decades and ensure that you have more than enough in savings when you retire. The COLAs from Social Security can help you keep up with inflation, and long-term gains from stocks can build your savings for retirement over time.
Future-Proof Your Retirement
Inflation acts as a silent drag on the value of your money by slowly diminishing the purchasing power of each dollar you save and consuming your savings faster. However, by consistently investing in a diversified portfolio with considerable exposure to stocks and saving wisely, you can future-proof your retirement from the worries of inflation and enjoy the retirement lifestyle of your dreams.