Retirement Risk: Inflation – Silent Erosion of Wealth
Inflation is often referred to as a “silent thief” in financial planning, subtly reducing the purchasing power of money over time. For retirees, inflation presents a unique and often underappreciated risk. Unlike working individuals who may see their wages increase with inflation, retirees typically rely on fixed income sources, such as pensions, annuities, Social Security, and investment withdrawals. Without proper planning, inflation can significantly erode a retiree’s standard of living, making it crucial to account for this risk in long-term financial strategies.
Understanding Inflation as a Risk
Slow and Steady Inflation
Most inflation happens gradually over time. It’s the gradual increase of the prices of goods and services over time due to increases in the cost of goods and labor.
Take the average cost of a gallon of fresh milk. In 1970, the average price of a gallon of milk was 73 cents. In 2024, that same gallon of milk now costs $3.85.
This steady rise in prices isn’t a bad thing if it’s controlled and if you are accounting for it in your financial plans.
When steady inflation becomes an issue is what you do not account for the rises over time or you underestimate inflation. Consider the following illustration with a starting portfolio of $100,000 and $5,000 per year withdrawals adjusted for inflation.
At 2% inflation, the portfolio still has over $80,000 after 30 years.
At 4% inflation, the portfolio depletes with 5 years remaining.
Inflation Pops
Inflation isn’t always slow and steady but can happen quickly. When this happens, prices rise rapidly before returning to a slow and steady state.
What is important to note here is that prices rarely deflate back to their previous levels to be consistent with the long term trend.
Taking the 2% inflation example from above. Let’s assume that there is 8% inflation in year 5 rather than 2%. With just a single year at that level, the projected 30 year balance of $81,700 drops to $55,000!
Inflation Impacts on Income
Inflation can have an impact on income as well. Some sources of income may be inflation adjusted like Social Security, Railroad, and some pensions. Most pensions and annuities do not adjust for inflation or may only adjust up to certain limits.
How to Address Inflation
1. Invest for Long-Term Growth, Not Just Income
Maintaining a well-diversified portfolio that includes equities is essential. While stocks are more volatile in the short term, they historically have been one of the best hedges against inflation. A balanced approach that combines growth assets with safer investments can help sustain purchasing power.
2. Delay Social Security Benefits
Social Security benefits increase by approximately 8% per year for every year delayed past full retirement age (up to age 70). Delaying benefits creates are larger benefit which is inflation adjusted. If your benefit is $25,000 per year, a 3% inflation adjustment boosts your income by $750. If your benefit is $45,000 per year, a 3% inflation adjustment boosts your income by $1,350.
3. Implement a Dynamic Withdrawal Strategy
Retirees can adjust withdrawals based on portfolio performance and inflationary trends. Strategies like:
- The Guardrails Approach, which adjusts spending based on portfolio performance, can help ensure sustainability.
- The Flexible Withdrawal Strategy, where retirees reduce spending during market downturns, allows assets to last longer.
4. Know What Income Adjusts with Inflation and What Income Does Not
It’s crucial to understand which sources of your retirement income are adjusted for inflation. Some sources of income may be inflation-adjusted, like Social Security, Railroad, and certain pensions. However, most pensions and annuities do not adjust for inflation or may only adjust up to certain limits. Identifying which income streams are vulnerable to inflation allows you to plan accordingly and seek alternative strategies to protect your purchasing power.
5. Maintain a Margin of Safety in Your Plan for the Unexpected
Building a financial cushion into your retirement plan can help absorb unforeseen expenses or economic shifts. This margin of safety ensures that unexpected costs, such as medical emergencies or sudden market downturns, do not derail your long-term financial stability. Regularly reviewing and adjusting your plan to account for potential risks can provide additional security.