Inflation is an insidious beast, and it’s surprisingly more dangerous than a market crash.
How would a slight increase in expected inflation impact your retirement plans? For the vast majority of my clients, inflation is the single biggest concern when stress testing the analysis and statistical models of their retirement plan.
And that’s saying something considering the stress tests I run are:
Equity market drop of 30% at retirement
Tax expenses higher by 20%
Reduction in Social Security of 20%
Health care costs higher by 20%
Client living 10 years longer than expected
And an inflation increase of just 1% (general inflation from 2.7% to 3.7%)
The graphs below show the stress test results for an actual client with the above criteria. The model projects thousands of possible future to get a probabilistic range of returns, and the bar graph shows the percentage of those possible futures where we run out of money before we run out of life.
Generally, we like the model ‘success rate’ to be between 65% and 75% (too high and we run the risk of unnecessarily sacrificing our lifestyle during retirement). As you can see, inflation being just 1% higher than expected (the dark yellow) has the single biggest impact. Even more than a 30% market drop at the worst possible time (beginning of retirement) or asset returns being 1% lower than expected.
What Will Your Monthly Retirement Income Purchase In a Few Decades?
A retirement income of $10,000 per month will only be worth $5,869 in 20 years with the historical average inflation rate — but if inflation is 3.7%, the number further drops to just $4,835. After 40 years that $10,000 will only be worth $3,445 with historical inflation and less than $2,500 at 3.7%.
Unfortunately, the biggest drop in your purchasing power often comes at a stage in life when healthcare costs are rising.
No Help From Social Security or Annuities
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Sadly, your retirement savings will have to take on nearly all of the impact of inflation by itself as Medicare Part B premium increases have historically eaten up all of Social Security cost of living adjustments. In addition, very few annuities have inflation adjustments and most pensions have adjustment formulas that fall far behind the historical inflation average.
Use Multiple Inflation Rates
What’s more annoying is that historical inflation isn’t a consistent 2.7% across the spending board. Healthcare, food, and other key categories inflate at different rates than general inflation. This is why our projections include separate inflation rates for specific expense categories, such as healthcare, which have higher inflation rates.
What Should You Do?
Make sure you are considering inflation and understand how your retirement income will be impacted by inflation. Look at your expected retirement expenses to see which ones are most susceptible to inflation, and which may be protected from inflation (such as any remaining mortgage).
Also, consider the timing of inflation. While the average inflation rate historically is 2.7%, you may experience higher inflation early in retirement and then lower inflation later to create that average. When this happens, the high, early inflation rate eats into your retirement savings due to your having to make larger early withdrawals. And this leaves less money to invest and compound, making the rest of your retirement projections inaccurate.
Want Help Managing Retirement Risks Beyond Investment Risk?
If you would like help with your retirement plan and managing inflation and the other risks above, schedule a confidential, 1-on-1 Retirement Rescue Session with a Certified Financial Planner.
Joshua Escalante Troesh, CFP, is a Tenured Professor of Business and the founder of Purposeful Finance. He works with people across the country on their financial planning needs through Purposeful Strategic Partners, a fiduciary and fee-only financial advisor and a Registered Investment Advisor.