If you don’t want to feel poor in your retirement, you’ll want to learn about inflation risk and adopt strategies to mitigate it. Inflation is a serious risk that can derail your retirement finances.
What Is Inflationary Risk?
Inflation increases the cost of goods and services over time. If your income doesn’t keep up with inflation, you run the risk of not having enough money to buy what you need to support the life you want.
There are a handful of economic measures of inflation; the most common measure is the Consumer Price Index, aka the CPI. It measures how prices change for a specified basket of goods and services that apply broadly across the U.S. population.
Since 2000, the average change in the CPI for each year has ranged from -0.4 (prices dropped slightly that year) in 2009 to 8% in 2022.
Inflation doesn’t apply uniformly across all goods and services; some items increase more than others. As a result, inflation will impact people differently, depending on the goods and services they typically need. For example, in recent years, inflation in medical goods and services has been higher than other goods and services, generally impacting retirees more than workers. You’ll want to focus on inflation in the costs of goods and services that you buy.
What Causes Inflationary Risk?
There are several factors that can cause inflation. One is an excess of demand over supply: When more people want to buy a specific item, it can drive up the price because retailers can sell their inventory at higher prices. Inflation can also be caused by increases in wages, which give people more money to spend and drive up the prices of goods and services.
Increases in the raw materials of goods can also cause increases in the prices of consumer goods. A drop in productivity is another cause of inflation; in this case, fewer goods are produced, limiting supply, and causing supply to fall below demand.
By now, you get the picture—inflation is a complex phenomenon that has vexed economists and planners for many years.
How Will Inflation Risk Affect Your Retirement?
People entering into retirement could be retired for two decades or more. Even with modest inflation of 3-1/2% per year, prices could almost double during that timeframe. Pre-retirees are even more vulnerable to inflation, since they will be investing for a few decades before they retire for another few decades.
People of all ages can address inflation risk by managing both sides of the common-sense formula for financial security: I > E, or income greater than inflation.
Pre-retirees will want their wages to keep pace with inflation, so that they have money left over after spending that can be devoted to saving and investing for retirement. Another strategy is to own your home, since the value of real estate has historically increased over time and kept pace with inflation.
Retirees will want to develop sources of retirement income that keep up with inflation, starting with Social Security benefits that are increased each year by the CPI. That’s one good reason to maximize the amount of your Social Security benefits.
Another way to help manage inflation risk is that anybody can make careful choices regarding their spending. Want to be less vulnerable to increases in the price of gas? Then buy cars that sip gas instead of gas-guzzlers. The bonus is that you’ll also help the environment in the process.
Want to be less vulnerable to increases in the cost of food? Buy less expensive packaged food and dinners and buy more fresh fruits and vegetables that are in season. Or buy low-cost frozen fruits and vegetables. You might also improve your nutrition and health in the process, possibly creating another bonus with lower medical bills.
By now you get the picture; carefully examine the goods and services that you buy and make smart substitutions that can help protect you against inflation risk.
What Can You Do To Mitigate Inflation Risk When Investing?
History shows that over the long run, investments in stocks have outpaced inflation. For example, one study reports that the change in the CPI between 1914 and 2022 averaged about 3.2%, whereas the S&P 500 earned an average return of 10.4% between 1926 through 2022. However, there have been periods when inflation was higher than stock market returns, so there’s no guarantee.
Another strategy is to broaden your concept of a retirement investment. For example, possibly consider investments in your home that reduce your energy bills and make you less vulnerable to increases in energy costs. Examples include insulation for your home, energy-efficient appliances, heat pumps, and solar panels.
Inflation is a long-term risk that can quietly eat away at your financial security over a few decades. It’s smart to plan ahead so that you don’t find yourself running low on money with many more years of good retirement life ahead of you.