How to Account for Inflation in Retirement Planning

Retirement planning is a critical process that can help secure your financial future. And understanding economic factors, like inflation, is essential. While inflation impacts all consumers, it can significantly affect retirees’ purchasing power or what a given amount of money can buy. Retirees may struggle to maintain their financial stability when their purchasing power is reduced. Therefore, it’s vital to understand and intuitively plan for inflation when creating a retirement budget and setting up an income plan.

A financial advisor can help you navigate inflation and other dynamic challenges involved in retirement planning.

What Is Inflation?

In its simplest form, inflation is the shrinking of your money’s value over time. More officially, inflation is the rate at which general prices for goods and services increase over time. Consequently, each unit of your money buys fewer products, decreasing your purchasing power. This economic state most impacts those relying on fixed incomes, like retirees.

Inflation is often expressed as an annual percentage, representing the average price increase for a basket of common goods. Central banks, like the Federal Reserve in the United States, aim to manage inflation to maintain economic stability. A moderate inflation rate of around 2% is generally considered healthy. ¹ It encourages spending and investment because people expect prices to rise, but not too quickly.

However, high inflation can erode your purchasing power. Suppose you have $100 today, and the inflation rate is 5%. In a year, those same goods and services that cost $100 will cost you $105. If your investments or savings don’t keep pace with inflation, you effectively lose money.

Throughout history, we’ve seen various instances of inflation. Following the COVID-19 pandemic, inflation hit 9.1% in the U.S. in June 2022. ² Common factors triggering inflation include increased production costs and heightened demands for goods and services, especially when supply is constrained.

How Inflation Affects Retirees

Inflation has a direct, noticeable effect on the funds that retirees lean on for support. Take, for instance, a retiree named Susan who recently started her retirement, having budgeted her annual expenses at $50,000. After 20 years, presuming an average annual inflation rate of 2.5%, Susan will need almost $82,000 to match her original purchasing power due to the increased cost of living.

This is just one example of how inflation can potentiate a higher cost of living for retirees, affecting their affordability of essential items like food, healthcare and housing.

How Inflation Impacts Different Types of Retirement Income

Retirees rely on different types of income during their retirement years, like Social Security benefits, traditional pensions, and retirement savings like 401(k)s or IRAs, among other sources. These types of incomes experience inflation differently. While Social Security benefits adjust for inflation, traditional pensions may not. Understanding how inflation may impact your different income streams in retirement is vital for building a plan to cope with it.

Let’s examine how inflation can impact various types of retirement income:

• Social Security: Social Security benefits are adjusted annually based on the Consumer Price Index (CPI). While this adjustment helps to some extent, it may not fully offset the effects of inflation, especially if healthcare costs, which tend to rise faster than the CPI, make up a significant portion of an individual’s expenses.

• Pensions: Some retirees are fortunate to have defined benefit pension plans. However, these too can be vulnerable to inflation. If the pension doesn’t have a cost-of-living adjustment (COLA), the purchasing power of the pension income may decline over time.

• Investments: Many retirees rely on investments like stocks, bonds and mutual funds for income. For example, if a stock increases in value by 7% in a given year, but inflation is 3%, the stock’s inflation-adjusted return is just 4%. Inflation can erode the real returns on these investments, making it crucial for retirees to have a diversified portfolio that includes assets that tend to perform well during inflationary periods, such as Treasury inflation-protected bonds and dividend-paying stocks.

• Annuities: Retirees who purchase annuities receive a fixed income stream for life. While this provides stability, it can also mean a reduced standard of living if inflation is not factored into the annuity terms. Some annuities offer inflation-adjusted options, which can help mitigate this risk.

• Rental income: If you own rental properties, rental income can be a valuable source of retirement income. However, rental income may not automatically increase with inflation unless you adjust your rental rates regularly.

Calculating Your Inflation-Adjusted Retirement Needs

Knowing that inflation reduces purchasing power is only the first step. The next is estimating how much income you’ll need in retirement after accounting for rising prices. Even relatively modest inflation can significantly increase annual living expenses over a retirement that lasts 20 years or more.

Estimate Your Future Retirement Spending

One way to estimate future expenses is to adjust your current annual spending using an assumed inflation rate.

Future spending = Current spending × (1 + Inflation rate)Years

For example, if you spend $60,000 per year today and inflation averages 3% annually, maintaining the same purchasing power would require about $108,400 per year after 20 years.

The longer your retirement lasts, the greater the effect inflation can have on your annual income needs. Even a one- or two-percentage-point difference in inflation can lead to substantially different spending requirements over several decades.

Compare Your Income Sources

After estimating your future expenses, compare that figure with your expected retirement income. This may include Social Security benefits, pension payments, annuity income and withdrawals from retirement accounts. If projected income does not cover anticipated expenses, you may need to increase your savings, adjust your retirement date, reduce planned spending or reconsider your withdrawal strategy.

It is also important to remember that some expenses may increase faster than overall inflation. Healthcare, insurance premiums, and long-term care costs, for example, have historically risen at different rates than the broader Consumer Price Index. Building flexibility into your retirement budget can help account for those differences.

Update Your Projections Over Time

Inflation assumptions are estimates, not guarantees. Reviewing your retirement plan periodically allows you to adjust for changes in inflation, investment returns and spending needs before they have a larger effect on your finances.

Revisiting your projections every few years, or after periods of unusually high inflation, can help you determine whether your savings, investment allocation and withdrawal plan remain consistent with your long-term retirement goals.

A financial advisor can help you model different inflation scenarios, estimate future retirement expenses and develop a withdrawal strategy designed to preserve your purchasing power throughout retirement.

How Retirees Can Plan for Inflation

Planning for inflation helps maintain the same living standard over retirement years. Let’s assume that a retiree requires $50,000 for the first year of retirement expenses. Due to a 2.5% inflation rate, they’ll need $51,250 for the next year’s retirement budget to maintain the same lifestyle.

Here are some strategies retirees can use to account for inflation in their financial plans:

1. Invest Wisely

One of the most effective strategies for combating inflation during retirement is to invest wisely. Consider allocating a portion of your investment portfolio to assets that historically outpace inflation, such as stocks or real estate. While these investments come with some level of risk, they have the potential for higher returns, which can help your money grow and keep pace with rising prices.

2. Bonds and TIPS

While stocks offer growth potential, they also come with higher volatility. Retirees often seek more stability. Treasury Inflation-Protected Securities (TIPS) and certain types of bonds can be a valuable addition to your portfolio. TIPS are indexed to inflation, which means their value rises with the cost of living. They provide a reliable source of income while shielding you from inflation’s erosive effects.

3. Review Your Budget

Regularly assess your spending habits and adjust your budget as needed. During periods of high inflation, it may be necessary to prioritize your spending on essentials and cut back on non-essential expenses. By doing so, you can ensure that your retirement savings will last longer. You’ll also need to account for inflation when withdrawing from your retirement accounts. You may need to increase your withdrawals by as much as 3% per year on average to keep pace with rising costs.

4. Optimize Your Social Security

Delaying your Social Security benefits can be a smart move to combat inflation. For every year you delay Social Security beyond your full retirement age (up to age 70), your benefits will increase by as much as 8%. These delayed retirement credits not only provides a larger income stream in retirement but also adjusts for inflation.

5. Diversify Your Income Sources

Relying solely on your retirement savings may not be the best strategy in an inflationary environment. Consider additional income sources, such as part-time work, rental income or dividends from investments. These can supplement your retirement income and provide a buffer against rising costs.

6. Consider Healthcare Costs

Healthcare expenses tend to increase with age. In fact, a study conducted by the Employee Benefit Research Institute found that men need $212,000 in savings to all but guarantee being able to pay for their healthcare needs in retirement, while women will need $252,000. ³ Make sure you have adequate health insurance coverage and consider contributing to a health savings account (HSA) – if you have access to one – to cover future medical expenses tax-efficiently.

Staying Flexible During Inflationary Spikes

Retirement planning shouldn’t be rigid but allow for flexibility, particularly during periods of unexpected inflation spikes. Don’t rush to make substantial purchases during high inflation, as prices could drop when inflation slows down. Modulating withdrawal rates during high inflation is another strategy to prolong the life cycle of retirement savings. Also, having readily accessible cash savings can cover immediate expenses, avoiding potential losses from selling investments during an inflationary period.

Bottom Line

Remember, inflation gradually erodes the purchasing power and value of retirement savings over time. By actively accounting for inflation in your retirement planning, you can enhance your financial resilience and maintain a consistent lifestyle throughout your retirement years.

Retirement Planning Tips

• A financial advisor can help you make important decisions regarding your retirement, including when to claim Social Security and how much to withdraw from your accounts each year. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• Knowing how much you might need to support your lifestyle in retirement and whether you’re on track to reach that goal are vital components of the retirement planning process. SmartAsset’s retirement calculator can help you estimate how much your current nest egg could grow over time.

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