You hear it all the time: you should make sure your retirement savings at least keep pace with inflation. But what is inflation and how does it really affect your retirement savings? 

In simple terms, inflation is defined as an increase in the general level of prices for goods and services. Deflation, on the other hand, is defined as a decrease in the general level of prices for goods and services. If inflation is high, at say 10% – as it was in the 1970s – then a loaf of bread that costs $1 this year will cost $1.10 the next year.

Inflation in the United States has averaged around 3.24% from 1914 until 2021, but it reached an all–time high of 23.70% in June 1920 and a record low of -15.80% in June 1921. Most will remember the high inflation rates of the 70s and early 80s when inflation hovered around 6% and occasionally reached double–digits.

But so far in 2021, inflation has gone up every single month – which you no doubt already know.

For comparison purposes, the inflation rate in Venezuela averaged 32.47% from 1973 until 2017, reaching an all–time high of 800% in December of 2016.

So how does inflation affect your retirement savings?

The answer is simple: inflation decreases the purchasing power of your money in the future. Consider this: at 3% inflation, $100 today will be worth $67.30 in 20 years – a loss of 1/3 its value.

Said another way, that same $100 will only buy you $67.30 worth of goods and services in 20 years. And in 35 years? Well your $100 will be reduced to just $34.44.

How is inflation calculated?

Fortunately for us, we don’t have to calculate inflation – it’s done for us. Every month, the Bureau of Labor Statistics calculates indexes that measure inflation:

• Consumer Price Index – A measure of price changes in consumer goods and services such as gasoline, food, clothing and automobiles. The CPI measures price change from the perspective of the purchaser.
• Producer Price Indexes – A family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.

How the Federal Reserve Attempts to Control Inflation

Up until the early part of the 20th century, there was no central control or coordination of banking activity in the United States. In fact, the US was the only major industrial nation without a central bank until Congress established the Federal Reserve System in 1913 with the enactment of the Federal Reserve Act.

With the Federal Reserve Act, Congress set three very specific goals for the Fed: to promote maximum sustainable employment, stable prices, and moderate long–term interest rates.

In order to help the Fed stabilize prices, Congress gave the Fed a very powerful tool: the ability to set monetary policy. And one way the Fed sets monetary policy is by manipulating short–term interest rates in an effort to control inflation.

If the Fed believes that prevailing market conditions will increase inflation, it will attempt to slow the economy by raising short–term interest rates – reasoning that increases in the cost of borrowing money are likely to slow down both personal and business spending.

The flip side is true too: if the Fed believes that the economy has slowed too much, it will lower short–term interest rates in an effort to lower the cost of borrowing and stimulate personal and business spending.

As you might imagine, the Fed walks a very fine line.

If it does not slow the economy soon enough by raising rates, it runs the risk of inflation getting out of control. And if the Fed does not help the economy soon enough by lowering rates, it runs the risk of the economy going into recession.

Currently, the Fed believes that “inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Fed’s mandate for price stability and maximum employment.”

What Investors Need to Remember

Therefore, it is imperative that your long-term retirement strategies account for inflation and that you prepare for a decrease in the purchasing power of your dollar over time. You should strongly consider assuming that inflation will be more than 3% – its historical average.

It’s true that inflation today hovers around 6% – triple the Federal Reserve’s target inflation rate – but a better assumption might be one based on the last 100–years of data. If you’re wrong and you find that the inflation rate for the next 25 years turns out to be 2%, then the purchasing power of your retirement savings will be more, not less.

YOUR FINANCIAL AFFAIRS – WHAT YOUR CHILDREN SHOULD KNOW

Many parents may find it uncomfortable, or even believe it is unnecessary, to inform their children about personal finance matters. Yet, communicating openly with your family members can help to reassure them about your financial and health care wishes. This may also ease the decision-making process for your family in many important areas.

As time goes by, informing your children of financial, estate, and medical arrangements that could affect the entire family helps everyone prepare and plan for the future. This does not need to include detailed facts and figures; however, you may want to consider sharing the following information with your adult children:

• Life Insurance. Life insurance is typically purchased to provide a death benefit to help cover final expenses, estate taxes, outstanding mortgages, other liabilities, and lost income. Knowledge of the existence and location of life insurance policies can be of the utmost importance to children when settling their parents’ finances in a timely manner.
• Other Insurance. Be sure to inform children of other insurance policies that you may have, including health, disability income, and long-term care insurance. If you’re age 65 or older, make sure your children have a basic understanding of Medicare coverage and are aware of any health insurance policies that exceed Medicare coverage. Older adults can greatly benefit when their children understand and follow appropriate procedures, as well as submit any necessary forms on deadline.
• Wills. Preparing a will allows you to avoid leaving the disposition of your estate up to your particular state and its probate laws. To help ensure that your assets are distributed according to your wishes, both you and your spouse should prepare wills, review them regularly, and make necessary updates as circumstances change. Although specific contents can be kept private, it is important to disclose the existence and location of wills to several family members or a trusted legal advisor. Keep in mind that bank safe–deposit boxes may be temporarily sealed at death, so you may want to choose an alternate location for this key document. For example, the original will may be left with your financial advisor for safekeeping.
• Trusts. Trusts can help protect your estate from unnecessary taxation or mismanagement. Make sure to discuss pertinent terms with those who will be involved. As children reach adulthood, it is common for parents to select a responsible son or daughter to act as trustee in the event of the parents’ death.
• Living Will. This document specifies your preferences regarding the administering or withholding of life–sustaining medical treatment. Under many state statutes, a patient must be considered “terminal,” “permanently unconscious,” or in a “persistent vegetative state” before life support can be withdrawn. Be sure to provide copies of living wills to anyone who may be involved with the health care of you or your spouse, and keep the originals in a safe, readily accessible place.
• Health Care Proxy. This legal document allows you to appoint a person to act as an agent on your behalf to make medical decisions, should you become incapacitated. It is important to file a copy of the health care proxy with your primary doctor and your hospital, if possible. In addition, be sure that the individual appointed as your agent retains a copy.
• Durable Power of Attorney. With a durable power of attorney, an individual or financial institution may act as an agent to oversee your legal and financial affairs, even if you become incapacitated. Grown children need to be informed of the steps that have been taken to ensure the competent direction of your finances, should the need arise. However, their actual involvement in your financial matters may be limited, according to your wishes. A power of attorney automatically terminates upon the death of the principal.
• Assets and Debts. It can be beneficial for your children to know that you have compiled a list of your assets and debts, even if you choose not to show them the list. An asset list updated regularly may include information on your bank accounts, real estate holdings, pension payments, annuities, business agreements, brokerage accounts, boats, cars, artwork, collectibles, jewelry, or other valuables, and insurance policies. A debt list may include information on your current mortgages, consumer indebtedness, personal loans, and business obligations. For both lists, be sure to identify where the paperwork and associated files for each item can be found.

Initially, preparing these lists and the associated documentation may seem like an overwhelming task. However, once completed, both you and your adult children may experience a sense of relief in the knowledge that thoughtful planning was discussed and implemented according to your wishes.

Planning For The Future

How does a wise (and retired) investor combat the danger of rising inflation and the lure of chasing returns? That’s easy, just remember the adage: “If it sounds too good to be true, then it probably is.”

And remember this: when you planned for retirement, you modeled out your financial expenses and lifestyle choices. But just because you’re retired, it doesn’t mean that your planning stops.

For example, retirees should ask how to calculate the future rate of inflation because projecting what price increases lie ahead is central to anticipating their annual income needs. And sadly, there is no magic number. Worse, often times the assumed number can be flawed and can vary significantly from one family to the next because your personal inflation rate is unique based on your age and your lifestyle. The headline CPI number is important only as a general gauge. The more we consider prices as they relate to goods of the economy – and the lifestyle of the investor – the more accurate we can be in estimating an inflation number.

When completing your financial plan, it is important to accurately project for inflation as you think about your investing plans to bring peace of mind.