In March 2015, the average price of a car was $33,021. By March 2016, that number had risen 2% to $33,666. If you bought a car in 2015 and then bought another one in 2016, you probably wouldn’t balk too much at paying 2% more. But if the last time you bought a car was in 1980, when the average price of a new car was $7,200, you’d be in for quite a surprise at the 468% jump in price.
We don’t usually notice inflation much over a year or two, but when you look at the big picture, it’s much clearer. On a year to year basis, inflation is usually pretty small.
What Does That Mean for Your Retirement?
But over time, it adds up. Inflation is incredibly powerful over long time periods – like your retirement. To give you a sense of just how big of an effect we’re looking at, let’s say we’re looking at a thirty-year retirement, and with inflation at 3.5% per year (the historical average of the US CPI, a measure of general inflation, is 2.9% per year from 1950-2015).
If you had $1,000,000 at the start of the period, thirty years later, that $1 million would be equivalent to about $356,000. Still a good deal of money, but only about one-third of what you started with.
You can minimize your inflation risk in other ways with your investment portfolio and your reserves, but it can be a big problem for your reliable income since you don’t have much flexibility.
Inflation Hits Retirees Harder Than Others
Some reliable income sources have a Cost Of Living Adjustment (COLA) that adjusts the payment to try to keep up with inflation, though this often falls short of the unique inflation rate retirees face.
Health care expenses tend to have (very) high inflation rates and retirees spend more of their income on health care than most other people. Social Security falls into this trap. It is subject to a COLA, but it is based on the inflation that office workers face. This might make sense from a funding perspective –office workers fund Social Security through their taxes – but it can leave recipients with smaller and smaller real incomes over time.
Even if COLAs don’t keep up with inflation, they at least defray some of the effects of inflation. A lot of other reliable income sources don’t have those COLAs, paying you the same amount every month forever (or however long you’re supposed to get paid).
Over time, even though the dollar amount stays the exact same, these payments effectively shrink, leaving you to take on all of the inflation risk yourself. This isn’t always a bad thing – having your payments increase with inflation means you will likely get a smaller payment to begin with.
But if you don’t adjust for inflation, you are front loading your income. That may or may not be what you actually want to do, but you need to be aware and account for the effects of inflation on the rest of your plan.
What Can You Do?
If a significant part of your reliable income comes from sources that are not inflation-adjusted, you can account for this in several ways. Here are three of the most common:
- Have other income sources (such as a deferred annuity) come on line as you start feeling the effects of inflation.
- Spend less as you age. This one can only get you so far, and it may not be an option as health costs rise with age.
- Getting more of your income from your investment portfolio as you age. This means that you will be taking on more investment risk, and will need to compensate for that.
There’s no optimal solution here. It depends on what risks you are willing to take, and which will keep you up at night.
 Data courtesy of Dimensional Fund Advisors.
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