How to Manage Inflation During Retirement

As we approach retirement, one of the biggest questions on our minds is: Will our money last? Most of us focus on our portfolio and its potential performance, hoping for the best but planning for the worst. What often gets overlooked, however, is the impact of inflation on our retirement savings.

Inflation can significantly erode purchasing power over time, making it a crucial factor in retirement planning. In fact, some of the worst times to retire in U.S. history were during periods of high inflation, like the 1970s and early 1980s. Here, we’ll explore the importance of factoring inflation into your retirement plan and share some strategies to help you manage it effectively.

The Role of Inflation in Retirement: Inflation is the gradual increase in prices over time, which reduces the purchasing power of your money. While it’s easy to focus on the performance of your investments, inflation can have a more subtle but equally devastating impact on your retirement. If inflation outpaces your investment returns, you could end up with less money than you anticipated to cover your living expenses.

For example, during the 1970s and early 1980s, retirees faced high inflation rates that significantly reduced the value of their savings. With inflation as high as 12-14% at times, retirees who hadn’t factored in this risk saw their purchasing power plummet, despite having saved diligently.

Planning for Inflation with Retirement Tools: Here is my favorite tool to map this out. Don't panic when you see the number, it is normal to see a rise in the amount of money you will need. Here are some guidelines to help you.

Here’s how each factor plays into your retirement:

• General Inflation: You can set both optimistic and pessimistic inflation rates for your overall expenses. Historical inflation averages around 3.28%, but the recent rate may be higher or lower depending on current economic conditions. For a balanced approach, you might set an optimistic inflation rate at 2% and a pessimistic one at 4%.
• Social Security Adjustments: While Social Security COLA is meant to adjust for inflation, it’s not always a perfect match. Social Security uses the CPI-W (Consumer Price Index for Wage Earners and Clerical Workers), which may lag behind general inflation. To be conservative, consider setting the pessimistic Social Security COLA close to your general inflation rate.
• Housing Inflation: Real estate values typically appreciate over time, but the rate of appreciation can vary. Since 1991, housing prices have averaged a 4.44% annual increase. It’s important to model this separately from other expenses, as it will affect your estate value but may not directly impact your day-to-day retirement expenses.
• Medical Inflation: Healthcare costs have historically risen faster than general inflation, sometimes as high as 7% per year. Given the rising costs of medical care and long-term care, it’s critical to include a higher inflation rate for medical expenses in your plan.

Managing Sequence of Returns Risk: Another important consideration in retirement planning is the sequence of returns risk. This occurs when poor investment returns early in retirement combine with inflation, leading to a rapid depletion of your portfolio.

One strategy for managing this risk is to model different rates of return over time. For example, you might assume lower returns in the first decade of retirement (e.g., 1%) and higher returns later (e.g., 9%). This allows you to prepare for the possibility of a bad decade early in retirement, where inflation runs higher than stock market returns.

The Impact of Inflation on Long-Term Care and Other Expenses: As you age, healthcare costs become an increasingly significant part of your budget. Retirement planning tools like New Retirement can help you model the impact of long-term care expenses, which are projected to be needed during the last few years of life for many retirees. Tools like this can model long-term care costs using specific assumptions about inflation, showing how these expenses will grow over time.

For example, if current long-term care costs are estimated at $14,400 per month, they may be much higher by the time you need care, depending on inflation. Adjusting these numbers for inflation helps give you a more realistic picture of what you’ll need in retirement.

Strategies to Combat Inflation in Retirement: While inflation is largely out of your control, there are steps you can take to protect your retirement savings:

• Diversify Your Investments: A diversified portfolio tilted towards equities (stocks) can act as a hedge against inflation. Historically, stocks have outpaced inflation over the long term, making them a good option for growth.
• Monitor Inflation Assumptions: Regularly review and update your inflation assumptions to reflect current economic conditions. You can use tools like New Retirement to experiment with different scenarios and see how inflation changes affect your overall plan.
• Maximize Income Sources: Consider maximizing Social Security benefits by delaying your claim, which can provide you with higher COLA adjustments and reduce the impact of inflation on your income.
• Consider Healthcare Costs: Be conservative in your estimates for medical inflation. While recent healthcare inflation has been low, long-term trends suggest it will continue to rise, making it crucial to plan accordingly.

Model Worst-Case Scenarios: By modeling both optimistic and pessimistic scenarios, you can understand how different inflation rates will affect your retirement. Planning for the worst-case scenario ensures that you won’t run out of money if inflation exceeds expectations.

Final Thoughts: Inflation is an unavoidable part of retirement planning, and understanding its impact can help ensure that your money lasts. By using retirement planning tools to model inflation, you can prepare for a variety of scenarios and make more informed decisions about your savings and spending.

This chart is powerful because it highlights the disparity between overall inflation and specific categories, such as auto insurance, which rose significantly more than the national average. Despite the nationwide inflation drop, essential costs like rent and restaurant meals continue to increase, creating financial pressure on everyday expenses. Furthermore, the decrease in prices for items like gasoline and used vehicles contrasts sharply with other categories, showing how inflation impacts various sectors differently.