Right now, inflation is top of mind for everyone, including retirees. Inflation is important. But it is only one of the risks that retirees have to plan for and manage. And like the other risks, you can build a plan so that rising costs (both actual and feared) do not ruin your retirement plan.

Inflation and Your Budget

Remember that in retirement your budget is different than when you were working, and you will be impacted in different ways. And, of course, when you were working your salary and bonuses might have gone up with inflation, which helped offset long-term increases in costs.

Much of your pre-retirement budget was spent on housing — an average of between 30% and 40%. Retirees with smaller or paid-off mortgages will have lower housing costs even as their children are busy taking out loans to buy houses, and even home equity loans to pay for home improvements.

On the other hand, while healthcare looms as a big cost for everyone, for retirees these expenses can increase faster than income. John Wasik recently wrote an article for The New York Times that cited a recent study showing that increases in Medicare Part B premiums alone will eat up a large part of the recent 5.9% cost of living increase in Social Security benefits. As Wasik wrote, “it’s difficult to keep up with the real cost of health care in retirement unless you plan ahead.”

Inflation and Your Sources of Income

To protect yourself in retirement means (a) creating an income plan that anticipates inflation over many years and (b) allowing yourself to adjust for inflation spikes that may affect your short-term budget. For the first, it’s important to look at your sources of income to see how they respond directly or indirectly to inflation.

  1. Social Security benefits that, once elected, increase with the CPI. Some retirees are fortunate enough to have a pension — and one that provides some inflation protection.
  2. Dividends from stocks in high dividend portfolios have grown over time at rates that compare favorably with long-term inflation.
  3. Interest payments from fixed-income securities, when invested long-term, have a fixed rate of return. There are also TIPS bonds issued by the government that track inflation.
  4. Annuity payments from lifetime income annuities, which generally are fixed, although those with increasing payments are also available.
  5. Withdrawals from a Rollover IRA account invested in a balanced portfolio of growth stocks and fixed income securities. While the returns will fluctuate, the long-term objective is to have a return that exceeds inflation.
  6. Drawdowns from the equity in your house, which can be accessed through various types of equity extraction vehicles. The drawdowns can be set at level or increasing amounts.

The challenge is that with these disparate sources of income, how do you create a plan that protects you against the inflation risk — as well as other retirement risks.

Key Risks That a Retirement Income Plan Should Address

A good plan for income in retirement considers the many risks we face as we age. They include:

  1. Longevity Risk of Outliving your Savings. Social Security, any pension and annuity payments provide guaranteed income for life and become the foundation of your plan.
  2. Market Return Risk. While occasional “corrections” in financial markets grab headlines and are cause for concern, you can manage by reducing your income’s dependence on these returns. Consider pushing the market risk (and reward) to your legacy.
  3. Inflation Risk. While a portion of every retiree’s income should be lifetime and less dependent on market returns, you need to build in an explicit margin for inflation risk. And in the process, accept lower income at the start. For example, under a Go2Income plan, our typical investor can plan on starting income of $114,000 under a 1% inflation assumption. It would be reduced to $103,000 under a 2% assumption.

So, what factors should you consider making that critical assumption?

Picking a Long-Term Assumed Inflation Rate  

Financial writers often talk about the magic of compound interest; in real numbers, it translates to $1,000 growing at 3% a year for 30 years to reach $2,428. Sounds good when you’re saving or investing. But what about when you’re spending? The purchase that today costs $1,000 could cost $2,428 in 30 years if inflation were 3% a year. So, when you design your plan what do you assume?

Here are some possible options:

  • Assume current inflation of 5.9% is going to continue forever
  • Assume your investments will grow faster than inflation whatever the level
  • Assume a reasonable long term-rate for inflation — and all of your other assumptions.

We like the third choice, particularly when you consider the chart below. Despite the dramatically high rate of today’s inflation that affects every result, the long-term inflation rate over the past 30 years was 2.4%. For the past 10 years, it was even lower at 2.1%.

A Long-Term View Smooths Inflation Spikes

Inflation and retirees

Managing Inflation in Real-Time

Whether you build your plan around 2.0%, 2.5% or even 3.0%, it is helpful to realize that any short-term inflation for you personally will not match your plan. My view is that you adjust to this short-term inflation in multiple ways.

  • Where possible defer purchases that are affected by temporary price hikes.
  • Where you can’t defer purchases, use your liquid savings accounts to purchase the items, and avoid drawing down from your retirement savings.
  • If you believe price hikes will continue, revise your inflation assumption and create a new plan. Of course, monitor your plan on a regular basis.

Inflation as Part of Planning Process

Go2Income planning attempts to simplify the planning for inflation and all retirement risks:

  1. Set a long-term assumption as to inflation that you’re comfortable with.
  2. Create a plan that lasts a lifetime by integrating annuity payments.
  3. Generate dividend and interest yields from your personal savings, and avoid capital withdrawals
  4. Use Rollover IRA withdrawals from a balanced portfolio to meet your inflation-protected income goal.
  5. Manage your plan in real time and make adjustments when necessary.

You can put together a plan at Go2Income here and also modify it by adjusting your expectations and investments. You may also ask for help from a qualified advisor who can answer questions and assist in navigating the process.

Inflation is a worry for everyone, whether you are retired or about to retire. An Income Plan that you design at Go2Income will help you create the best approach to inflation and all retirement risks you may face.