Your Retirement Plan's Silent Killer: Inflation
Submitted by InFocus Financial Advisors, Inc. on May 18th, 2017
Depending on who you ask, the biggest risk to a retiree can be one of many. One of the biggest that seems to be a back of mind item and often the least talked about, is inflation. Inflation is something we all know exists, and have felt and dealt with over the course of our lives. By definition: “a general increase in prices and fall in the purchasing value of money.”
Why do I consider this one of the biggest risks for retirees? It is essentially the carbon monoxide to your retirement plan if you do not address and make a plan for it. You really don’t feel the impact of it in any one month, or year but it is this gradual erosion of the value of your money. How do you plan for it? As you went through your working career, employers generally increase wages on a fixed scale or other measure and it is intended to combat these inflationary forces. It was never really a concern of yours for the last 20, 30 or 40 years as your income kept up with the prices. But what about now? Managing your income and spending is now solely your responsibility.
I frequently ask classes that I teach if Social Security is an inflation adjusted source of income for retirees. The answers are mixed. The answer is yes and no. Let’s first acknowledge that Social Security does have a Cost Of Living Adjustment or COLA. That adjustment is based on the economic measure of inflation called CPI-W (Urban Wage Earners). CPI-W is a measure frequently used by many pension and other defined benefit plans as well. Of note, if you have a defined benefit plan you will want to make sure it has any inflation adjustment at all! The Bureau of Labor Statistics (BLS) who keeps these economic measures has been recently experimenting with a new index called CPI-E (Based on households with referenced individuals at age 62 or over). The intent was to model how inflation affects retiree’s specifically as opposed to a much larger collection of urban wage earners. The conclusions have been interesting. What the BLS found is that CPI-E has grown about 8.3% more than CPI-W over the last 31 years (JPMorgan).
So what does this mean? While your Social Security benefit has been increased to help with the effects of inflation, it probably hasn’t fully kept up. For retiree’s, that means more pressure is added to their withdrawals from their savings to make up the difference. For some, that can have a drastic effect on the probability of not running out of their savings in retirement. From a portfolio standpoint, what you will be spending is going to be critical to your actual portfolio construction. Your initial withdrawal rate in the first 5 years of retirement has the biggest impact on your final portfolio value. The more you are spending, and the higher the initial withdrawal rate the more inflation is going to have a negative impact. If you are starting with a high withdrawal rate, because of the pressure added due to the short-comings of pension and Social Security COLA’s you can be put in the precarious position of an undesirable outcome and potentially run out of assets mid-retirement.
Once you have an idea of what you will be spending, you can start thinking about portfolio composition. Historically, equities have provided the best inflation-adjusted returns and provided investors with growth above inflation. This of course comes with the market risk of equity-like volatility. Bonds historically have for the most part kept-up with the pace of inflation, and of course provided less volatility. Whichever investment strategy or instrument is suitable for you, the biggest thing is sticking with it. Know where your withdrawals will come from, and which investments you will liquidate to provide income as the market rises, and conversely as it corrects. A balanced portfolio, and sound strategy will help you not only counteract the impact of inflation but potentially increase your odds of a desirable portfolio outcome.
If you would like to take a closer look at the impact of inflation on your strategy, sign up for our free one hour retirement checklist consultation below.
Investments in securities do not offer a fixed rate of return. Principal, yield and/or share price will fluctuate with changes in market conditions and, when sold or redeemed, you may receive more or less than originally invested. No system or financial planning strategy can guarantee future results.
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