Last week I talked about what inflation is and how it affects expenses over time. This week, I wanted to dig into how inflation affects retirement planning. After all, inflation is basically a given. Sure, deflation may occur in some years. And inflation isn’t a physical truth, so I guess technically we could magically turn into a world where inflation stopped happening.
But I live in the real world, so for the sake of argument I’m going to assume that inflation is going to continue occurring.
What Does This Mean For My Retirement Planning?
When you are planning out your retirement, you need to take inflation into account. Your retirement plan should include thoughts on how to overcome inflation. After all, your expenses are going to go up over the course of 20-50 years of inflation. You need to have a plan for that eventuality.
I always start my retirement planning by looking at what it would cost me to support the lifestyle I want in “today dollars,” then adjust from there for inflation. So if my lifestyle costs $50,000 in 2017, I look at how well my retirement plan could replace $50,000 today. Once I have that figured out, I start looking at how it would replace $50,000 + inflation the following year, and five years after that, and twenty years after that.
That may mean investments that are expected to out-earn the inflation rate, an inflation-adjusted pension, or having more money in the bank than you think is strictly necessary. Or, your plan might be to lower your expenses as you get older. That’s not really a good plan all by itself, IMO, but I have known people who did that. Especially people who retired late in life.
Here are the things I’m looking at.
Expenses and Inflation
First, I need to estimate how inflation will cause my expenses to rise over time. Much as with predicting investment returns, I can’t know the future. But I can look at past inflation rates and make an educated guess.
The Bureau of Labor Statistics (BLS) keeps track of the CPI and allows you to look at various situations on this handy dandy page. Personally, I like to modify the Change Output Options at the top to look at different time periods. I also check the box to include annual averages which gives me a nice picture over time but doesn’t make things too detailed.
Looking at this, I can see how inflation rates have changed over the last several decades. I can also start to get an idea of what to expect. For instance, I can see that inflation hasn’t been above 3% since 1994. I can also see that 1974-1982 must have been AWFUL!!
Anyway, using this chart I can model how my expenses are going to rise. For instance, let’s say my annual expenses right now are $50,000. Pretend I want to retire in 10 years. At an average annual inflation rate of 2.5%, my expenses in 2027 would be about $64,000. If the inflation rate averaged 4%, my average annual expenses would be about $74,000. That’s a $10,000 difference caused by a 1.5% average inflation rate change!
So the first step of calculating how much my expenses are expected to rise is to estimate a reasonable average inflation rate.
How Much Inflation Should You Plan For?
That’s a good question.
Depending on which time period you look at, inflation might have been a low 2% average, or a scary as heck 7% average.
Using the BLS, you can find the monthly and annual averages for every year from 1958 to the present. And you can use them to figure out what to expect.
(Thanks Bureau of Labor Statistics for the fun data set!)
Knowing that inflation rates have equaled or exceeded 4% twenty-two times over the last 59 years, it seems reasonable to me to expect a rate closer to 4% rather than 2.5%. I can also look at the average inflation rate since 1957, which is 3.74%, to see the same thing.
Or, I can say “the 70s and 80s were weird” and only look at, say, the last 30 years of data. That’d give me an average inflation rate of 2.64%.
For an idea of how much that changes things, let’s say you are spending $50,000 annually right now and want to retire in 20 years. At a 2.64% average increase, you would need to replace $84,198 annually. At a 3.74% average increase, you’d be looking at replacing $104,206. That’s $20,000 additional income needed annually from only a 1.1% inflation difference!
I’m gonna be honest. I don’t know enough about inflation to know whether the 70s and 80s were weird. They were definitely periods of abnormally high inflation, but it could certainly happen again. So for my own planning, I use an estimated inflation rate of 3.5%. To me, that’s a good balance of long term averages and recent inflationary memory.
Investment Returns
The next thing I consider is my expected annualized returns on my investments vs inflation.
Let’s say an investment is reported to return 10% one year. Does that mean you have 10% more purchasing power the next year? Not necessarily. Inflation is going to cut into that return.
Since the BLS has detailed inflation data available going back to 1958 on that table, I’m going to look at the 1958-2016 timeframe, using different chunks.
Using this really nice calculator from Moneychimp I can see how much the S&P 500 returned in average annualized and “real” (inflation adjusted) returns.
From 1958-2016, the average annualized return was 10.39% including dividends. Once you adjust for the inflation over that time, the real return is 6.65%. That may sound like a much worse result, but remember that’s how much more the money is worth after accounting for inflation. That means you would have 6.65% more purchasing power.
And between 1987-2016, the annualized return was 10.19% while the inflation-adjusted real return was 7.36%. While the annualized returns between these two time periods was about the same, the lower inflation rate from 1987-2016 means the investment had a much better real return during the period of lower inflation.
Inflation-Fighting Retirement Income
In addition to planning for investments that earn more than inflation, there are some other things you can do that will help you ensure your income continues to rise in retirement. The easiest, most reliable way to do this is to have an income source that rises with inflation.
The most common program like this in the United States is a little program known as Social Security. I’m certainly not going to tackle the entire Social Security program in this post. That could be (and is) the basis for many, many books.
But one thing Social Security has going for it is that it is inflation adjusted by law, since 1975. The purpose of the Social Security Cost of Living Adjustments (COLA) is to ensure that purchasing power of the benefits is not eroded by inflation.
I know, I know, Social Security’s COLA adjustments don’t always rise at the same amount as the BLS CPI. And/or you believe Social Security won’t be solvent by the time you reach Social Security age. Like I said – way too much there to discuss in this post. Just know for now that Social Security is inflation adjusted.
Other inflation-fighting ways to earn income in retirement are COLA-adjusted pensions and annuities. Also both topics that will require more in depth looks at another time, but definitely something to consider when you are looking at your retirement plan.
What I’m Doing
Personally, I’m taking a multi-pronged approach to this problem.
First, there is my possible military pension, which is COLA-adjusted. A pension that would cover all of my expected expenses that also rises with inflation is a huge benefit. And when I get older, I do still expect to receive at least some Social Security. How much remains to be seen, but I think it will be helpful if nothing else.
Second, I invest very aggressively and while I don’t plan to invest quite this aggressively in retirement, I still plan to have a high enough percentage of stocks in my portfolio to ensure my long term total returns beat inflation.
Third, I have flexibility in my planned retirement budget to lower my bills somewhat if needed. Like I said, I don’t think this should be the only step someone makes in planning for inflation, because you never know whether you will actually be able to shrink your budget when you need to. But in combination with the other things, it can help for a short-ish period of time.
And finally, as I’ve mentioned before, by planning to retire early I leave myself plenty of time to earn more money if needed. That gives me some flexibility in ensuring my retirement portfolio is large enough to beat both inflation and recessions/depressions over the long haul.
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