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Americans learned last week that inflation slowed in July, but consumer price growth was still nearly triple the historical average. Inflation plays a major role in retirement planning, and we’re not off the hook yet. Fortunately, an informed approach can calm some investors’ fears and provide a roadmap for navigating a difficult economic environment.
The current state of inflation
Wall Street applauded the news that the July consumer price index report indicated inflation was weaker than expected and slowing. This is obviously good news for many consumers, especially retirees on a fixed budget, but it is just as important for investors. There is hope that the economy is normalizing, which means the Fed’s aggressive rate hikes are working. Importantly, it means the Fed may not have to pursue extreme monetary tightening, reducing the likelihood of a recession.
Before we all take a victory lap, it’s important to recognize that July’s inflation rate was still 8.5%, with food costs up almost 11%. Although there is progress and a light at the end of the tunnel, this problem does not disappear overnight. Now is not the time to give up on retirement planning.
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Inflation and retirement
Inflation has always been a major risk to manage in retirement planning. Most people experience a pay rise that partially offsets the effect of inflation, but you only get this built-in defense if you’re still working. Retirees live on a fixed income, while prices keep rising. Over the course of 30 years, the purchasing power of a dollar is roughly halved, even at historically normal levels of inflation.
Retirement planning is about making sure a household has enough cash to meet their financial needs and lifestyle goals. We can’t really hope to stop inflation – it’s not something anyone can control. Instead, it is important to recognize the effects of inflation and take steps to manage them.
If you are young, do not panic
Anyone under the age of 45 probably shouldn’t worry about this current spike in inflation when it comes to retirement planning. The cost of living has almost certainly gone up permanently, but there are a lot of factors working in your favor. Rising wages are a major contributor to inflation, and they rose 6.7% last month. Obviously, this doesn’t benefit everyone equally, but most people in the workforce will now earn more money until the end of their working lives. It will also increase social security contributions, which should lead to higher payments in the future.
It is also important to understand that the value of many assets is also pushed up with inflation. House and stock prices tend to rise with long-term inflation. Eventually, you should be able to sell your house for more than you otherwise would. Similarly, higher prices translate into higher sales and corporate profits, and stock prices should reflect this. Obviously, market conditions play a major role in asset values, but the overall long-term effects are helpful.
This is one of the main reasons why it is important to maintain a fairly aggressive allocation with equity exposure during the early years of your 401(k) or IRA. Growth is a proven and effective way to mitigate inflation risk.
The playbook for retirees
Things are a little more complicated for people who are retired or close to retirement. As you get closer to the end of working life, there is less money to earn and fewer years for assets to grow. Fortunately, there are built-in safeguards to protect retirees, and some important strategies can help as well.
Some inflation protection is provided to you. Social Security checks are adjusted each year for increases in the cost of living, so retirees’ monthly checks are expected to increase significantly in 2023. Some people who have defined-benefit pension plans also get ‘regular or ad hoc cost-of-living (COLA) adjustments. ) to their income. If you happen to be collecting retirement benefits, the COLA policy is an important and often overlooked part of your retirement plan. People enrolled in Medicare who do not pay premiums also benefit, as the rising costs of hospital care are borne by taxpayers.
This still does not meet all the challenges. Most people over 50 have significant exposure to bonds in their retirement accounts, and high inflation can really erode the value of bonds. That’s why it’s important to keep shares in your 401(k) or IRA, even after you stop working. You’ll always benefit from growth, and inflation hedging can save your life. If you’re worried about market risk, consider dividend-paying stocks that produce income whether the market goes up or down.
Retirees can also rely on instruments such as Treasure Inflation-Protected Securities (TIPS). These are treasury bonds whose value increases with inflation. They generally carry lower interest rates than other bonds, but they are an excellent tool for minimizing both inflation risk and volatility. There are a number of reputable exchange-traded funds (ETFs) that hold these securities, so you don’t even have to worry about managing this investment.
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