One factor that many people overlook when calculating their retirement number is the impact of inflation. In simplest terms, inflation means that the price of everything goes up over time, on average. The cost of housing, groceries, energy, gas, insurance and more all increase over time because of inflation.
Over time, those cost increases start to eat into how much you’re able to actually buy with your savings. You may have a lot of money saved for retirement, but if prices keep inching upwards, the amount of stuff you can buy with that money gets smaller and smaller.
How big of an impact does that really have? And what can you do about it?
It’s important to note that inflation has a large impact both on people seeking a traditional retirement and on people in the FIRE movement seeking early retirement. It can be doubly important to people using hybrid strategies, like the coasting strategy.
How inflation affects retirement
Let’s start with the basics. Inflation is the increase in prices over a period of time. In the United States, the “official” measurement of inflation is the Consumer Price Index, which has shown an increase in overall prices of slightly more than 2% per year over the past decade.
What about retirement? It’s impossible to forecast exactly how much a typical retirement portfolio will rise in value in the future, but analysts at Goldman Sachs forecast a 6% average return over the next 10 years.
What do those numbers mean?
How much money can retirees lose to inflation?
One great model for thinking of inflation in terms of retirement is to think of it as a hidden fee that’s charged to you every year, one that you will face no matter where you go. It doesn’t show up in your statements, but rather in terms of what you can buy with your dollars.
For example, let’s say you had $100,000 in your retirement account in 2010. By 2020, provided it went up in value at a rate of 6% per year, your account balance would be about $179,084. But if inflation is about 2%, you’re paying a “hidden fee” from inflation of $57,185 over 10 years. This mean your buying power decreases.
In other words, if you stick with the 6% average annual return projection noted above and inflation stays around 2%, you’ll lose more than half of your gains to inflation each year.
5 ways to avoid losing retirement savings to inflation
What can you do to minimize the impact of the “hidden fee” of inflation on your retirement savings? Here are five things that can help.
Use tax-advantaged retirement vehicles
While retirement plans like Roth IRAs and 401(k)s do not directly help with inflation, they do help reduce your tax burden on the money you earn within that account, which can help offset the impact of inflation when you withdraw funds. This is particularly true with Roth accounts.
When you put money in a Roth IRA and then withdraw it when you reach retirement, you do not have to pay income taxes at all on the money earned within the account.
With a traditional workplace 401(k), you still typically save money on taxes, but it’s relative. Your contributions to those accounts aren’t taxed today, meaning that your tax bill is immediately lowered, but you will have to pay taxes on all of your withdrawals from that account later. At that point, your tax rate will theoretically be lower as you’re earning less in retirement, so you’ll pay less taxes that way.
This won’t directly impact inflation, of course, but it will mean that you pay less in taxes on your retirement money than just using an ordinary investment account.
Invest some of your savings in the stock market.
One great way to protect yourself against inflation over the long term is to be more aggressive by investing in things that offer a higher average annual rate of return than inflation. Investments with a higher average annual rate of return tend to fluctuate a lot from year to year but average out over the long haul to a nice level.
The stock market is a great example. Stock investing is highly volatile, meaning that you will face years like 2008 where 40% of the value of the stock market vanishes, but that’s balanced with many, many years with returns well over 10% per year. That’s why stocks work over the long term — you might have a few bad years in there, but the sheer number of good years more than make up for it.
Consider including a healthy portion of stocks in your retirement investments, particularly if you’re far from retirement or if you have more than ten years of living expenses in your retirement accounts.
Avoid long-term investments with a low rate of return
More cautious investors may want to invest in things that offer little volatility and hold their value without much risk of losses. The problem with these types of investments is that, when interest rates are low like they are now, they offer little return, and even in periods where interest rates are high, that’s usually coupled with higher inflation.
If you want to use these types of investments to make your portfolio safer, do so, but don’t lock your money into long-term investments of this type while interest rates are so low, or else they will lag far behind inflation in the future if interest rates and inflation go up. Avoid long-term CDs, treasury bonds, and long-term bonds of any kind.
Buy inflation-protected securities
Another strategy to consider if you want your money to be as safe as possible while still matching inflation is to invest in Treasury Inflation-Protected Securities, or TIPS. These investments are backed by the federal government and their face value goes up over time to match the rise of inflation.
What’s the catch? TIPS usually have a fixed negative interest rate applied to them, which is common in periods of very low interest rates. How does a negative interest rate work on an investment like this? It’s subtracted from the face value of the investment whenever interest is calculated. So, while TIPS will keep pace with inflation, in practice it actually just keeps pace with inflation minus 0.5% or so during periods of very low interest. You’ll still lose ground to inflation, but it will be a very small and very steady amount.
Buy real estate
A final option to consider is to simply invest your money into something that has traditionally risen at a rate somewhat higher than inflation, and that’s real estate. Real estate can be a powerful vehicle for retirement investing, particularly for early retirement.
Why does real estate usually (not always, but usually) beat inflation? First, the cost of real estate is a part of how inflation is calculated because housing costs are a part of inflation. Second, real estate is a fixed item — there won’t suddenly be more land, so as more people are born and want more land for themselves, the value goes up. It’s supply and demand, and there will never be more supply.
Note that real estate is much like stocks — it has volatility, meaning that there will be years where the value increases far faster than inflation, whereas in other years the value may actually decline or grow at a rate lesser than inflation. You’re buying real estate for the long term, where those years average out.
Too long, didn’t read?
Remember when things used to cost a lot less than they used to? That’s inflation at work. Inflation simply means that prices are going up over time. Unfortunately, that has a negative impact on your retirement, as prices will be far higher when you retire and your retirement savings simply won’t go as far as they would today. How do you fight back? Use tax-advantaged retirement accounts. Invest in things that usually beat inflation over the long term, like stocks and real estate. Consider inflation-protected securities for your safest investments. Avoid long-term, low-interest investments. Those moves will help you overcome inflation’s negative impact on your retirement plans.
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Source: thesimpledollar.com