How Big of a Threat Does Inflation Pose to Your Retirement?

As America’s economy reopens, we’re seeing higher inflation rates, and this unwelcome surge should prompt retirees to consider the threat it could pose to their financial security.

The 5.4% rise in the consumer price index (opens in new tab) in the last year marked the highest inflation in almost 13 years. If you remember the soaring, double-digit inflation rates of the 1970s, you may be worried now. However, even if inflation never reaches those levels again, you still need to consider the eroding effects it has on your nest egg over the long haul.

How Much Will Your Money be Worth in 10 or 20 Years?

Even moderate inflation can have a significant effect on a retiree’s savings. The Federal Reserve’s target inflation (opens in new tab) rate is 2%, but the Fed has said it will allow inflation to rise above that mark for some time. Let’s take a look at how an average annual inflation rate of 3% over the next 20 years would impact your finances.

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If you needed $60,000 for your first year of retirement, in 20 years you would require $108,366.67 to match today’s purchasing power (opens in new tab) of $60,000. Another way to look at it: At 3% annual inflation, that initial $60,000 would be worth only $33,220.55 in 20 years.

You need to factor inflation into your retirement plan because you can expect that everyday items, travel and other expenses will continue to rise in cost. Inflation erodes the value of savings and will continue to do so after you retire. Considering the near-zero interest rates of savings accounts, retirees who are living off their savings are especially vulnerable to high inflation. Therefore, it’s important to assess your investment strategy and retirement income plan to see if you’re protected against inflation for the long term.

Social Security Is Not Keeping up

The Senior Citizens League estimates that the average Social Security benefit (opens in new tab) has lost almost a third of its buying power since 2000 because benefit increases have not kept up with the increasing cost of prescription drugs, food and housing. This has occurred despite yearly cost-of-living adjustments (COLAs) for Social Security benefits that are meant to make benefit amounts keep up with inflation.

Social Security beneficiaries saw a relatively high cost-of-living adjustment (COLA) of 2.8% in 2018 (for the 2019 benefit year). In 2020, they saw a 1.3% increase (for the 2021 benefit year). In some years, the COLA adjustment (opens in new tab) has been nonexistent or practically so. It was 0.3% for 2016 and 0% for 2015. Lawmakers have proposed changing how COLAs are calculated to make benefit increases better reflect the price increases older Americans see.

Consider what would happen if all your retirement income lost a third of its value over the course of 20 years. Would that scenario make it more likely that you will run out of money?

What can You Do?

So, how can you know how much income you will need in retirement when inflation insists on complicating the situation? Here are some things to keep in mind:

• First, consider any fixed-income sources in retirement that will not likely keep pace with inflation. In the process, consider how much interest you are earning from money in a savings account or CD. It’s unlikely that we will see a substantial interest rate hike in the next few years, so be prepared to continue earning little interest. It’s important to assess your investment strategy and retirement income plan to see if you’re protected against inflation for the long term.
• Next, calculate how much your nest egg is right now. As you do, factor in inflation over the next 10, 20 and 30 years. Consider that while overall inflation rates may fall from what they are now, that might not be true for some of the specific goods and services that could take a large chunk of your income, such as energy, food or health care and long-term care costs.
• Consider whether your current investment strategy will need to change once you retire. You may want to contemplate a strategy that continues to grow your money in retirement, so when transitory events like inflation hit, you’re covered. Foundationally, a solid plan ensures that your purchasing power needs are always met. Some people may need to take on less investment risk once they near and reach retirement. However, having the right risk asset allocations for your particular situation could help combat the eroding effects of inflation on your nest egg over the course of your retirement.

Finally, consult a professional. Today’s retirees face a triple threat of potentially high inflation, persistent low interest rates and an unpredictable market. We could see the aftereffects of the pandemic for years to come, so make sure you have a solid retirement plan in place to help you weather storms like rising inflation.

Dan Dunkin contributed to this article.