How to Deal with Inflation in Retirement

When you’re planning your retirement, you know that there may be factors that you can’t predict or control. Inflation is one of those factors and has recently taken a real bite out of everyone’s wallet, something that is especially concerning for retirees. We’ll discuss inflation and your retirement plan, what you need to know.

Over the last thirty or so years, inflation hasn’t been much of an issue. Between 1990 and 2021, the annual average rate of inflation was a manageable 2.38%. Anyone making their retirement plans in those decades knew inflation could impact their portfolios. Still, it wasn’t a significant concern for most people because it had been relatively low for so many years.

But inflation has skyrocketed in recent months. At the time of writing, inflation is at 7.9%, a 40-year high. Now what was once a vague possibility is right on our doorsteps.

What is Inflation and Inflation Risk?

Inflation is an increase in the cost of goods and services. When prices rise, the amount of goods and services our dollar can buy decreases. In 2021, the inflation rate was 4.70%; today, the rate is 7.87%. So if a newspaper cost $1 in 2021, it will cost $1.05 now. When your money is worth less, you have to spend more to cover the increase in prices. When you’re on a fixed income, as many retirees are, this can pose a huge problem.

Inflation risk is the risk that inflation will undermine an investment’s performance, the value of an asset, or the purchasing power of an income stream.

The impact inflation has on investments depends on the type of investment. For those with a set annual return like regular bonds or CDs, inflation can hurt performance. You earn the same interest payment each year, so inflation can cut into those earnings.

Inflation is a mixed bag for stocks. Inflation typically means a strong economy. In a strong economy, companies may be selling more which can increase their share prices. But companies are paying more for wages and raw materials, hurting their value.

Some commodities like gold have historically been “inflation hedges.” As the dollar loses value, it costs more dollars to buy the same amount of gold.

And some investments are indexed for inflation risk. They earn more when inflation goes up and less when it goes down, so total earnings are less volatile. Some bonds and annuities are inflation-indexed.

Estimating Inflation Expenses During Retirement

Trying to figure out how much money you need to retire can seem impossible. No one can predict the future after all! Luckily, there are a few solid rules of thumb you can use to get a pretty good ballpark estimate of your yearly expenses during retirement, and from that, calculate how much you need to save for retirement.

One rule of thumb is that you’ll need 80% of your pre-retirement income for every year of retirement. That number is easy enough to calculate.

The 4% Rule projects that with the right mix of stocks and bonds (50/50), you can withdraw 4% of your portfolio for living expenses every year for at least 30 years and never run out of money. If you need $40,000 a year, you’ll need to save $1 million. The 4% Rule has its critics, but it still provides a good starting point for estimating expenses during retirement.

You can also get more customized numbers that take into account things like your current age and rate of savings, estimated retirement age, and household income with a retirement calculator.

And it’s the job of your financial professionals to help you remember and account for the unknowns like tax rates, inflation, and market volatility when planning your retirement.

Social Security Adjustments

If you’re not yet receiving Social Security benefits, you can calculate your potential benefits. While benefits don’t automatically get a cost of living adjustment (COLA) every year, they are generally increased when the cost of living goes up.

Starting in January 2022, there was a COLA of 5.9%, the biggest jump since 1983. Why? Inflation. The previous year, the increase was just 1.3%, but inflation was much lower at the time. In terms of money, the average benefit increased by $92 for a total of $1,657 per payment.

You can maximize your Social Security benefits by waiting as long as possible, ideally until you reach 70, to start drawing benefits.

Medical Costs

It’s not exactly a secret that healthcare costs are out of control. Just how out of control might surprise you (And require medical care!). The prices for medical care were 222.65% higher in 2021 than in 1990, the same spread we used to look at inflation rates above. In that time, medical care had an average inflation rate of 3.85% per year. So a $1 medical expense in 1990 would have cost you $3.23 in 2021.

Medicare premiums and prescription drug prices have been impacted by inflation. The government recently announced that Medicare Part B premiums for 2022 would rise 14.5%, making the standard monthly premium $170.10. Last year the cost was $148.50.

Since these costs don’t look to be coming under control anytime soon, it’s best to be proactive as you can naturally expect to require more healthcare as you age, and Medicare doesn’t cover all medical expenses.

Perhaps the most important thing you can do to protect your retirement investments is to buy Long-Term Care (TLC) insurance. Each year Genworth publishes a very comprehensive report on the cost of LTC and provides a great calculator that shows costs in your specific area. The numbers are alarming and eye-opening, and if you’ve been on the fence about buying LTC insurance, this will convince you.

Health Savings Accounts (HSAs) are another great way to plan for medical expenses and one of my favorite investment vehicles. HSAs help those with high-deductible health insurance plans save taxes on money used to pay medical costs not covered by the insurance plan.

HSA contributions can be rolled over from year to year and offer three advantages; contributions aren’t taxed, the money grows tax-free, and it isn’t taxed when withdrawn to pay for eligible medical expenses.

Retirement Savings Strategies To Combat Inflation

Your focus for retirement investing should be tax-advantaged accounts like Roth IRAs, Traditional IRAs, and 401ks. If you’re not currently maxing out those accounts, make it your goal to do so.

Is your portfolio balance too conservative? Stocks are riskier than bonds but offer better returns, and you’ll need those higher returns to combat inflation. Real estate tends to do well during periods of inflation because landlords can pass on increased costs to tenants. If you don’t want to become a landlord, you can invest indirectly in real estate through Real Estate Investment Trusts (REITs).

And, of course, the ever unpopular cut your spending advice! This is especially unwelcome as we’ve all been cooped up for two years and are finally ready to spend some money! But now is not the best time, especially if you’re nearing retirement or recently retired.

This Too Shall Pass

All good things and all bad things like pandemics, bear markets, and inflation have one thing in common; they don’t last forever. We haven’t seen inflation this high for many years, so it’s new and startling for many people, but it too shall pass. Make the necessary adjustments, and you’ll come out the other side.