Minimizing inflation’s effects on retirement nest eggs
Several factors can cause savings to dwindle quicklyJune 16th, 2016
With life expectancy increasing and traditional defined-benefit pension plans disappearing, many Americans are fearful of outliving their savings and running out of money in retirement.
How do you know how much money you’ll need? Retirement planning is complicated by the many unknowns: You don’t know how long you’ll live. You don’t know whether you’ll incur significant medical costs or need expensive long-term care. You don’t know how the market in general and your specific investments in particular will perform over time. You don’t know the future rate of inflation.
Retirement planners use actuarial and historical data to make educated predictions about these variables while incorporating a variety of different investment tools and strategies to reduce your risk in any one area.
When it comes to inflation, most planners use a figure of 3 percent—the approximate historical average since 1913, when the Federal Reserve was created and the government began tracking inflation. However, we all know that averages can disguise fairly wide swings, and if inflation happens to hit 10 percent right when you need to start withdrawing from your savings, your money won’t go nearly as far as you had hoped.
In its efforts to promote price stability and maximum employment, the Federal Reserve targets an annual inflation rate of 2 percent over the medium term. If it were any lower, the economy would be at greater risk of experiencing deflation, which causes a variety of negative economic outcomes, including increased unemployment.
But the Fed’s balancing act certainly isn’t an exact science, and the U.S. economy is too complex and too integrated with international markets to enable precise control through manipulation of interest rates and the money supply. Inflation has been low for the past few years—the Consumer Price Index increased just 0.7 percent in 2015, following a 2014 increase of 0.8 percent—but we can’t expect this trend to continue indefinitely.
Because inflation and interest rates are closely connected, zero-risk investments such as savings accounts and CDs almost never grow at a rate that keeps up with inflation. So as a retiree, even if you make only small withdrawals from your savings account, you’re bound to see your nest egg dwindle quickly as inflation erodes the value of your money.
For example, if the historical average of 3 percent inflation holds, a savings account of $200,000 would be worth only $148,819 in 10 years, $110,735 in 20 years, and $82,397 in 30 years.
Or, looked at another way, if you expect to live on $50,000 per year in today’s dollars, in 10 years, with 3 percent inflation, you’d need $67,196 to have the same purchasing power, $90,306 in 20 years, or $121,363 in 30 years.
During your working years, pay raises generally help your earnings keep pace with inflation. Once you retire, though, you won’t be getting any more raises. Social Security income is adjusted for inflation, as are some pension payments, but to make sure you won’t outlive your money, you’ll need to carefully manage your own savings and investments in a way that takes inflation into account.
Financial planners are always preaching the value of a diversified portfolio, and that advice holds true for retirees as well. The aim is to manage risk by investing in assets—stocks, bonds, cash, real estate, etc.—whose returns don’t typically move in the same direction, as well as by further diversifying within each asset class.
Your particular balance of assets will depend on your financial goals, age, tolerance for risk, and other factors. While it’s true that stocks generally should make up a decreasing share of your portfolio as you get older, it’s important not to be too conservative, because stocks are your best bet at earning returns that outpace inflation over time. For many retirees, running out of money is a far greater risk than investment loss.
Many financial planners today recommend investing for total return rather than income, abandoning the arbitrary division between principal and interest and allowing withdrawals to be funded from any portion of the portfolio that makes sense at that moment, as long as a sustainable withdrawal rate—4 percent is frequently agreed to be reasonable—is maintained.
That said, many retirees do like to acquire some dividend-paying stocks—or mutual funds including dividend-paying stocks—as a way to supplement their fixed income. These stocks provide retirees with a record of consistent growth to reduce risk and a high enough yield to provide income.
“Dividend aristocrats” often are appropriate to consider: large-cap blue-chip companies in the S&P 500 Index that have increased their dividends every year for the past 25 years. Past performance is no guarantee of future results, but a company with a solid track record is generally judged to be less risky.
Beyond investment vehicles, there are other steps you can take as you enter retirement to help limit the risk that inflation will eat away too much of your savings. These can include, reducing your fixed expenses, continuing to work part time for a few years, and delaying tapping into Social Security until age 70 in order to receive the maximum benefit.
In addition, it’s always important to confirm that you are obtaining maximum value with your investments by paying attention to the fees, commissions, and taxes.
Talk to your financial adviser about minimizing the impact of inflation as you create your investment and retirement spending plans. A bit of advance preparation can give you peace of mind and help you face this new stage in life with confidence.
Rob Blume is managing director and senior vice president of Wealth Management and Advisory Services at Washington Trust Bank. He can be reached at firstname.lastname@example.org.