Objective information about financial planning, investments, and retirement plans

Don’t Underestimate Inflation

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Inflation

 

Given the current economic environment inflation may seem like a non-existent threat. In fact we are hearing about the possibility of deflation on some of the financial newscasts. While nobody can predict the future, its unlikely that inflation is dead. Some say that within a few years the various economic stimulus measures currently being put into place will trigger the next round of inflation. When planning for retirement ignoring the impact of inflation can prove to be disastrous.

An inflation rate of 2% or 3% per year, over a period of many years, can seriously erode the purchasing power of your funds. At 2.5% inflation, $1 today will be worth 78 cents in 10 years, 61 cents in 20 years, and 48 cents in 30 years. That can have a major impact on those entering retirement for several reasons:

New retirees are less likely to have defined-benefit pensions. Thus, they must rely more on Social Security benefits and personal savings, including defined-contribution plans such as 401(k) plans.

Cost of living adjustments for Social Security benefits are less generous. While Social Security benefits are still adjusted for inflation based on the consumer price index (CPI), the methodology for calculating the CPI changed dramatically in 1999, reducing increases in the CPI.

Retirees are living longer. As life expectancies increase, retirees are spending more years in retirement, so their retirement savings are subject to the impact of inflation over a longer time period.

Health-care costs are becoming more of a burden to retirees. More and more companies are reducing benefits or eliminating health care insurance for retirees, and health-care costs tend to increase faster than overall inflation. For instance, in 2006, the overall CPI increased 3.2%, while medical care costs increased 4.0% and hospital and related services increased 6.4% (Source: Bureau of Labor Statistics, 2007).

To combat the effects of inflation on your retirement income, consider these tips:

Use a conservative inflation rate for planning purposes. Since your retirement is likely to span decades, consider inflation over long time periods. For instance, while inflation has averaged 2.54% over the past 10 years, it has averaged 4.31% over the past 30 years (Source: Bureau of Labor Statistics, 2007).

Consider investment alternatives likely to stay ahead of inflation. Thus, a significant portion of your portfolio will probably be invested in stocks, which have typically earned returns in excess of inflation. While it may be tempting to move away from equities after the market losses of the past year, doing so may impact your ability to stay ahead of inflation. Your investments should be diversified among various vehicles based upon your risk tolerance, your income needs, your age, etc.

Invest in tax-advantaged investment vehicles. Look into 401(k) plans, individual retirement accounts, and other retirement vehicles. While each has different rules for taxing contributions and earnings, all provide some tax-free or tax-deferred benefits. Since you aren’t paying income taxes on earnings throughout the years, that typically means you’ll have a larger balance at retirement than if you were paying taxes throughout the years. Thus, you’ll start out with a larger retirement base to help combat inflation’s effects.

Keep fixed expenses as low as possible. Try to enter retirement with as few debts as possible. If you aren’t using a significant portion of your income to pay a mortgage, car payment, or credit card debts, you’ll have more flexibility to deal with higher prices.

Decide how you will deal with health-care costs. While Medicare will help once you turn age 65, it still does not cover many health-care costs. Look into Medigap policies and prescription coverage to help with those noncovered expenditures, especially if your employer does not provide health insurance after retirement.

Minimize withdrawals from your retirement assets, especially during the early years of retirement. To counter inflation, you need to withdraw larger and larger sums just to maintain the same purchasing power. To make sure you don’t run out of funds late in life, keep withdrawals during the early years to a minimum. Conventional wisdom in the financial planning world says that 3%-4% can generally be withdrawn each year. The reality is that you will need to manage and potentially adjust your annual withdrawals based upon factors such as inflation and investment return.

Be prepared for change. After retirement, keep a close eye on your investments. If inflation increases and you are concerned that increasing withdrawals may deplete your investments, you may want to look for ways to reduce your living expenses or go back to work at least part-time.

Please feel free to contact me with your retirement and financial planning questions.

Photo credit:  Wikipedia

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