When it comes to saving for retirement, there are plenty of potential pitfalls to avoid. But one that often gets overlooked is failing to plan for inflation, because inflation can be one of the biggest threats to sustaining income throughout your retirement.
Inflation is the rate of increase in prices over a given period. Based on the Consumer Price Index (CPI), annual inflation has historically averaged around 3%, but in recent years, it’s been closer to 2%. This means that while inflation hasn’t been a significant factor recently, it’s not unreasonable to think that at some point down the road, inflation will rise.
Why Rising Inflation Can Be Problematic
The reason that rising inflation can be such an issue is because its effects go largely unnoticed. If the market falls 2-3% in a year, you’ll notice the drop on your account statements. With inflation, it’s hard to notice its effects. There is no 2-3% drop in your statements because of the higher cost of goods and services. You’ll simply pay a bit more for the things you regularly purchase. When your cost of living rises every year, the same amount of money buys less and less over time.
That loss of purchasing power can really add up. Assuming a 3% annual rate of inflation, a family that lives on $50,000 today will need over $90,000 in 20 years to maintain that same standard of living. For retirees living on a fixed budget, those higher costs can pose a significant challenge.
What You Can Do to Take On Inflation
While it may slow down (or even stagnate), inflation, unfortunately, isn’t likely to go anywhere. Since 1914, there have only been 13 instances of deflation (prices declining), most notably during a seven-year stretch around the Great Depression. This means that in the last 107 years, prices have increased annually in 94 of them. So, it stands to reason that inflation is something you should expect and plan for. But what can you do?
Diversification
One way to combat inflation is to maintain a well-diversified portfolio both before and after you retire, which means including an allocation to equities. It’s important to remember that diversifying your allocation based on your time horizon can actually help to lessen your market risk.
It helps to think of your retirement income in terms of buckets of money. One bucket has short-term money that is very liquid and low risk, allowing you to meet any expected or unexpected daily expenses. Another bucket has your mid-term money. This bucket should have a mix of assets that can include fixed-income investments and a few equities to help pay for any costs you may encounter 5-15 years from now. The third bucket has your long-term money (money you’ll need 15 or more years down the road) hand should generally be a heavy allocation of equities. This portion potentially helps you outpace inflation.
By diversifying your assets based on your time horizon, you’ll be able to pull money from safer sources over the short term while still having exposure to the potentially higher returns in the stock market. That way, if there is a market correction, you will hopefully be shielded from the brunt of it.
Treasury Inflation-Protected Securities
A second option is to add Treasury Inflation-Protected Securities (TIPS) to your portfolio. TIPS help eliminate inflation risk to your portfolio, as the principal is adjusted semiannually for inflation based on the CPI while providing a real rate of return guaranteed by the U.S. Government. This means that unlike traditional fixed-income investments, TIPS limit the risk of inflation in your portfolio and help protect your future purchasing power. However, it’s important to note that TIPS are subject to market risk and significant interest rate risk, as their longer duration makes them more sensitive to price declines associated with higher interest rates.
A diversified portfolio is constructed in an attempt to minimize your risks, and one of the most important risks to guard against is inflation. Taking the time to speak with a financial advisor who can review your portfolio and evaluate whether you have a plan for inflation can help protect your retirement spending for years to come.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risks. Stock investing involves risk including loss of principal.
