How Does Inflation Affect Retirement?

There’s no denying the impact that inflation can have on every aspect of our lives. As prices rise, we all need to think about what we’re spending, what we have saved and how our spending can impact our future plans.

At Addition Financial, we have been spending a lot of time in 2022 talking to our members about inflation and its impact on their financial planning. One of the questions we’ve been hearing a lot is this:

How does inflation affect retirement?

That’s an essential question to ask because the choices you make now can resonate for years to come. Here’s what you need to know about inflation’s impact on your retirement income and spending.

How Does Inflation Impact Retirement Savings?

Let’s start with the question that looms the largest for people who are either already in retirement or approaching retirement age. How will inflation affect your retirement savings?

The short answer is that inflation reduces the buying power of a dollar. When inflation is high and prices rise, every dollar you earn or have saved has less buying power than it did before. 

The biggest concern for retirees is that they will outlive their savings. That worry is a realistic one when runaway inflation is in the picture. 

For that reason, it’s important to look at your retirement savings and think about what you will need to buy and how you can stretch your savings to accommodate higher prices.

How Does Inflation Impact Your Retirement Spending Needs?

Spending in retirement requires careful budgeting for most people. Even if you have Social Security payments, a pension and withdrawals from an IRA or 401(k), the chances are good that your total income will be less than it was when you were working.

When you consider your reduced income in conjunction with rising prices, the problem becomes clear. Let’s look at an example.

According to the United States Department of Agriculture (USDA), the cost of a gallon of milk in Miami was $3.95 in January of 2022. By July of 2022, the price had risen to $4.54 per gallon, an increase of almost 15%.

When we talk about purchasing power, we’re referring to how much each dollar will buy. A dollar in July of 2022 buys less milk than it did in January of 2022 – and still less than it did in 2021. The same is true of almost any product or service you use. According to the US Bureau of Labor Statistics, the Consumer Price Index rose 9.1% between June of 2021 and June of 2022

To give you an idea of how high inflation is in 2022, keep in mind that the Federal Reserve plans for 2% annual inflation. That means that our current inflation rate is more than four times higher than expected.

The impact of inflation on retirement spending can be profound. If you have a million dollars saved and you’re expecting to live on $40,000 per year (4% interest), you might need to adjust your expectations thanks to higher inflation. $40,000 isn’t going to buy as much as you might have anticipated. You might need $50,000 per year to live the same lifestyle you could have enjoyed for $40,000 per year with normal inflation.

free inflation infographic

How Does Inflation Affect the Way You Plan for Retirement?

Anybody who is planning for retirement should know how inflation affects their planning. It’s not as straightforward as understanding that your retirement savings may have less buying power in a period of high inflation. It can impact other areas of planning as well.

Inflation as a Benchmark

The federal government uses the rate of inflation as a benchmark when making decisions that can impact people who are already retired as well as those who are planning for retirement.

The first thing you should know is that the government considers inflation when deciding how much people can contribute to qualified retirement plans. During an inflationary period, the government may increase contribution limits to 401(k) and IRA plans to allow people to save more and increase their buying power in retirement.

The government also uses inflation to evaluate Social Security benefits and may increase payouts when inflation is high. For example, the Social Security Administration raised benefits by 5.9% in December of 2021. The increase is tied to the cost of living, which is impacted by inflation.

Pensions and Inflation

The rules about pensions and inflation are difficult to pin down because private companies who offer pensions typically have internal rules about how (or if) they will adjust payments for cost of living.

Said another way, pensions may or may not scale with rising inflation. If you have a pension, then we suggest reading the fine print and clarifying any questions you have about how inflation may affect your payments.

Budgeting for High Inflation

It’s common for retirement planning to include an estimated budget. The budget should tell you how much money you expect to receive each month and each year and how you plan to spend it.

When inflation is high, it affects every aspect of your budget, from spending on necessities such as healthcare, food and utilities to how much you will have for discretionary spending for travel and leisure.

If you are approaching retirement age, you should revisit your budget and make adjustments as needed. For most retirees on a fixed income, there will be a need to allocate more money for necessities and less for leisure activities when inflation is high.

Investing for Inflation

People who are close to retirement age may need to adjust their budgets due to inflation in 2022, but what if you’re younger and planning for retirement?

One of the most common mistakes people make is investing too aggressively as a hedge against inflation. High-risk investments are not a sure thing and it’s not possible to make up for a lack of retirement savings with risky investments. In fact, the risk involved could backfire and lead to you losing money if the stock market takes a turn.

How Much Do You Need to Retire with Inflation?

There are many factors that can impact how much money you need in retirement. These include the following:

  • Your age when you retire
  • Your life expectancy
  • Your anticipated spending
  • Cost of living

Some of these things are predictable, such as the age when you retire. Some are not. While life expectancy can be a useful benchmark, it’s not a sure thing. You might live far beyond the average life expectancy and if you do, you’ll need more retirement savings than you would if you had a shorter life span.

You can calculate retirement savings that factor in inflation by examining a variety of scenarios. For example, one scenario might assume 2% inflation, a 7% return on investments and a 25-year life expectancy after retirement, while another scenario might assume 4% inflation, a 5% return on investments and a 35-year life expectancy.

You can use our free calculators to determine how long your retirement savings will last and how much your retirement savings will be worth in the future.

It’s important to note that high inflation periods tend to be few and far between. Inflation in 2022 is high due to an unprecedented confluence of events that included a global pandemic, a struggling economy bolstered by stimulus payments and a war in Europe. You may want to save a little extra for retirement to allow for inflation but there’s no reason to panic.

What Rate of Inflation Should You Use to Calculate Your Retirement Savings Goal?

We mentioned above that the Federal Reserve assumes a 2% inflation rate when making financial projections. We recognize that with inflation as high as it is in 2022, people may want to use a higher number to build some cushioning into their retirement savings.

The recommendation used to be that retirement planning should assume a 3% inflation rate. When we look at historic inflation rates, inflation nearly always comes in somewhere between 1.5% and 4%. There are obvious exceptions, such as the runaway inflation in the 1970s and early 1980s. 

What you should know is that between 1973 and 1982, inflation was over 4% every year and in some years rose into the double digits. However, since 1983 – a nearly 40-year span – the number has exceeded 4% in only seven years: 1984, 1988, 1989, 1990, 1991, 2021 and 2022. We should note that the country fell into a recession during the presidency of George H.W. Bush, who was in office from 1989 to 1993. 

What’s the takeaway from these numbers? In short, most people will be fine if they assume a 4% rate of inflation for retirement savings and spending. The probability is that inflation will be under 4% in most years, so assuming 4% will build a cushion into your savings and allow for a worst case scenario situation.

One of the most effective ways to account for inflation is to invest in vehicles that keep pace with inflation. Examples include gold, Real Estate Investment Trusts (REITs) and a diversified stock portfolio. 

Inflation may be high in 2022, but there are things you can do to augment your retirement savings and protect yourself against inflation. The key is taking inflation into account when calculating how much you need to save and putting your money into investments that keep pace with inflation.

Do you need assistance with retirement planning? Addition Financial is here to help! Click here to learn about our MEMBERS Financial Services program and book an appointment with one of our Financial Professionals today.

The content provided here is not legal, tax, accounting, financial or investment advice. Please consult with legal, tax, accounting, financial or investment professionals based on your specific needs or questions you may have. We do not make any guarantees as to accuracy or completeness of this information, do not support any third-party companies, products, or services described here, and take no liability or legal obligations for your use of this information.