Multiple factors affect how much money you need to save for retirement, but perhaps none has a greater impact than inflation. Many people overlook inflation altogether when planning for retirement, while others severely underestimate its effect on their savings. The truth is inflation amounts to the single biggest danger to your retirement security; therefore, you must plan carefully.
Defining Inflation In Common Sense Terms
According to www.yourdictionary.com inflation is “an increase in the amount of money and credit in relation to the supply of goods and services.” Inflation occurs because an increasing supply of money and credit is trying to purchase the same amount of goods. This oversupply of “money” makes each dollar worth less.
Since the creation of the Federal Reserve System in 1913 the purchasing power of your money has consistently declined over time. What that means is you will need more and more money to buy the same amount of stuff and afford the same lifestyle in retirement. This makes your retirement planning a moving target rather than a fixed target which is very important to understand.
For example, at a modest but steady 3% inflation rate your cost of living roughly doubles every 24 years. In other words, 24 years from now it would take $2 to purchase the same goods and services that $1 buys today. A 5% inflation rate – something that has occurred over extended periods in history – can double your cost of living every 15 years.
According to Charles Ellis in “Winning The Loser’s Game”, a $100 item purchase in 1960 would cost $500 in 1995. That is 4.8% compounded annually causing an 80% reduction in your purchasing power. Anyone contemplating retirement in 1960 would have needed five times as much spendable income just to break even with inflation 35 years later. This would have been very difficult to do because over the same time period (late 1960’s to early 1980’s) the un-weighted stock market declined roughly 80% in value after adjusting for inflation.
Notice that these are 20 to 30 year time periods we are discussing and very representative of what retirees can expect to experience. Inflation that can cut your purchasing power by one-half or one-fourth can dramatically effect when to retire. It means that having enough money today could be only one-half or one-fourth the amount of money you need while in retirement. Clearly this is a critical issue to understand for your financial security.
How Does Inflation Threaten How Much I Need For Retirement?
One particularly troubling aspect of inflation effecting retirement planning is that nobody can accurately predict what the rate of inflation will be in the future. Economists have spent entire careers studying the subject yet remain notoriously inaccurate when forecasting future inflation.
This problem is compounded by the fact that traditional financial planning models require an estimate for future inflation in order to determine how much money you need to retire. In other words, the best and brightest economists in the world have failed at forecasting inflation; yet, you are required to do exactly that for the remainder of your lifetime in order to accurately determine how much money you need to retire. Whether you do-it-yourself with an online retirement calculator or utilize a financial planner’s services, the mathematical model that determines when you can afford to retire requires an inflation forecast. There is no way around it.
The solution recommended by most traditional financial planning models is to assume inflation will be 3%. This figure is based on relatively recent history (the last 20 years or so). However, using a broader historical context shows decades where inflation ranged between 5% and 10%. During wartimes it has escalated to 20% and during recessions inflation has plummeted to negative numbers. Clearly, assuming the 3% rule could be wildly inaccurate, and possibly inadequate, for future retirement planning as the range of possible outcomes is far wider than most financial planners acknowledge.
Several factors could work together to push inflation beyond the customary 3% during the course of your retirement: complications resulting from the current financial crisis and all the bailouts, massive government debt, Social Security and Medicare obligations, and the retirement of the Baby Boom generation. Still, estimating inflation is really just an educated guess, with an emphasis on “guess.”
How Do I Compensate For Inflation?
One approach to managing the threat of inflation during the retirement planning process is to use a range of inflation assumptions varying from conservative to aggressive. For example, when working with online retirement calculators you can apply a range of inflation estimates from 3% on the low side (conservative) to 6% or greater on the high side (aggressive) thus creating what is known as a “confidence interval”.
The conservative inflation estimates might cause you to under-save for retirement by underestimating the destructive power of inflation, and the aggressive inflation estimates might cause you to save more money than is necessary creating a margin of safety. As long as you manage your retirement savings for the more aggressive extreme this process can help create peace of mind and confidence in your retirement security.
If aggressive estimates for inflation cause an excessively burdensome retirement savings goal that is out of reach then there are alternative solutions. For example, most retirement calculators automatically increase your spending each year based on the inflation rate which increases the speed at which you draw down your savings. Instead, you could choose to carefully monitor your spending and inflation trends during retirement. Give yourself a raise only during years when inflation is noticeable or when your retirement savings grow significantly to offset the increased spending. When inflation does not occur maintain your current spending level, thereby preserving more of your principal that will continue to grow and help offset future inflation. This strategy will reduce the total savings you need to retire.
Another approach to managing inflation’s destructive effects is to invest in assets expected to grow with inflation thus offsetting its negative impact. For example, you may want to consider Treasury Inflation Protection Securities (known as TIPS) or income producing real estate. TIPS are specialized securities that adjust with inflation and have specialized pricing models and risks that must be understood before investing. Real estate income and values typically rise with inflation over the long-term thus offsetting the declining value of the currency it is priced in. In short, there are many investment and financial planning strategies to offset the risk of inflation when planning for retirement.
In Summary
The key point is to realize that inflation will likely decrease the purchasing power of your savings between the time you begin planning for retirement and the time you spend your last dollar. What seems like a lot of money today may not be enough money for retirement in the future. Your purchasing power could easily be cut in half or worse while you are living on your retirement savings. That is a very big deal that can dramatically impact how much money you need to retire.
Although it is impossible to accurately predict inflation, it is dangerous and potentially devastating to your retirement to underestimate inflation or not to consider it at all. In this case, ignorance is not bliss and you must make a plan of action to compensate for inflation. Adding this small extra step can go a long way toward ensuring that your nest egg will last a lifetime.
About The Author
Todd R. Tresidder retired securely when he was just 35 years young. His book, How Much Money Do I Need To Retire, teaches the lessons he had to learn to plan his own retirement security. His web site offers many retirement planning resources including educational articles and retirement coaching services.
