How Inflation Affects Your Retirement Savings: And What You Can Do About It

By Mitchell J. Smilowitz, CPA

Given the current historically low level of inflation, is it still an issue for retirement savers and those using their savings to finance retirement expenses? Since 2009, inflation averaged about 1.8% per year. Over the last 50 years, inflation has averaged about 3.2% annually. The Federal Reserve aims for a 2% annual rate of inflation.

Even at the current low levels of inflation, however, the cumulative effects are significant.

Inflation Erodes the Value of Investments and Savings

Despite the low level of inflation, prices have increased nearly 20% since 2009. In other words, you’ll need $1.20 today to buy what $1.00 bought in 2009. Viewed from the 50-year average rate of inflation, 3.2%, you can expect prices to double in approximately 20 years.

Here’s an example. Beginning in 2019, Rabbi Sarah saved $6,000 each year for 30 years. She averages a 7% rate of return and, in 2049, Rabbi Sarah retires with a nest egg of $606,438. During the 30 years in which Rabbi Sarah built her retirement savings, inflation averaged 3%. This reduces the spending power of Rabbi Sarah's savings to $249,844 in 2019 dollars.

Even assuming the best-case scenario – inflation averaging 2% over 30 years – the purchasing power of Rabbi Sarah’s retirement savings is reduced to $334,796 in 2019 dollars. To look at it differently, a home that costs $335,000 today could cost over $600,000 in 30 years, based purely on the effect of inflation.

Over the course of your working and retired lives, inflation will continue to erode the purchasing power of your retirement savings. As you save, remember that food, transportation and healthcare are also likely to cost significantly more than they do today.

Social Security Cost-of-Living Adjustments Don’t Keep Pace with Inflation

Social Security remains a major source of income for most retirees. To counteract the impact of inflation, Social Security provides an annual cost-of-living adjustment (COLA). The COLA for 2019, 2.8%, was the largest in seven years.

While the COLA improves the ability of Social Security benefits to keep up with inflation, the COLA calculation may understate the impact of inflation for many retirees. The Social Security Administration uses the Consumer Price Index (CPI) to determine the size of the COLA. The problem is that the CPI underweights sectors such as healthcare that have experienced price increases much greater than the overall rate of inflation. Because healthcare costs generally take a larger portion of our income as we age, many retirees may find that the Social Security COLA does not adequately keep up with inflation.

Finally, some propose reducing the COLA in order to prevent the depletion of the Old Age and Survivors Trust Fund. This change may further reduce the inflation protection Social Security provides for future retirees.

Increase Your Retirement Contribution to Combat Inflation

Increasing your retirement contribution each year offers an excellent way to protect your retirement savings from the effect of inflation. The goal is to invest 10-20% of your salary in your retirement account. If this is more than you can currently afford, invest as much as you can with the goal of increasing your contribution by 1% of your salary until you reach the targeted amount. If you contribute 5% of your $75,000 salary to retirement this year ($3,750), you would increase the contribution to 6% ($4,500) the following year. If you increase your contribution when you receive a raise, the impact will be negligible on your take-home pay.

At a minimum, consider increasing your contribution by 3% each year to counteract the impact of inflation. If you contribute $6,000 to your retirement account this year, you would increase your contribution by 3%, to $6,180, next year. While this approach allows you to keep up with inflation, if does not compensate for a low savings rate.

Factor Inflation into Your Investment Choices

The question for retirement savers is how to mitigate the impact of inflation. The answer lies in creating a diversified portfolio that includes equity investments.

Returns on equities have averaged 10% since 1926, exceeding the average rate of inflation. A portfolio overly weighted towards bonds may have difficulty keeping pace with inflation. Over the last decade, bond and CD yields have sometimes been below 2%.

The proportion of your portfolio invested in stocks needs to reflect your comfort with risk, but there is a rule of thumb you can use to estimate an appropriate proportion of stocks in your portfolio from a long-term investment perspective. Subtract your age from 110. The result is the approximate proportion of equities your portfolio should include.  If you are 30, consider a portfolio of 80% stocks and 20% fixed income. If you’re 70, the proportions would be 40% in stocks and 60% in fixed income.

While past performance is no guarantee of future results, this strategy generally allows investors with a long time horizon to manage the impact of inflation.

Unsure if your retirement investments are adequately hedged against inflation? Contact the JRB to run a projection that estimates the impact of inflation on your retirement investment account. Or call us at 888-JRB-FREE (572-3733).