As you approach retirement age, chances are you have built up some retirement savings by contributing to an employer-sponsored retirement plan, IRA or other retirement account. You may also be eligible for Social Security benefits or a pension once you reach retirement age. After you retire, you may well want to maintain your current income. Many retirees even find that having more time on their hands means they’re inclined to spend more than they did before. Being able to do this and have a comfortable retirement is a matter of optimizing your retirement plan to reach your longer-term retirement goals. However, when it comes to post-retirement financial planning, there are several factors investors commonly underestimate or overlook.
Investors in or near retirement often think holding the “safest” investments will guarantee a steady stream of retirement income. They also think safety allows for easy access to their money. It sounds like a smart strategy, but it can neglect to consider the impact inflation may have on those investments.
Inflation is insidious. It steadily decreases your purchasing power over time. If you rely on a steady monthly income after you retire, say, from a fixed-income bond coupon, Social Security or pension payment, inflation can indirectly decrease the amount of your income by eating away at its value. You need to account for inflation when planning your retirement.
Americans have experienced relatively modest inflation in recent years. Nevertheless, even a steady 3% annual inflation rate can prove significant over time.
The figure below shows the impact of inflation on your spending power.[i] Suppose you have decided today you need $50,000 per year to cover your retirement expenses. Factoring in a 2.97% inflation rate, in 20 years, you would need close to $90,000 a year just to match the original purchasing power of your $50,000 estimation. In 30 years, you would need over $120,000 to match the purchasing power of your original amount!
This example assumes an annual inflation rate of 2.97%. The example is provided for illustrative purposes only.
If you are relying on a fixed annual income of $50,000, then you can see how inflation will reduce the value of that income very substantially in 20 or 30 years.
If you are looking either to increase the value of your nest egg or to simply preserve the purchasing power of your capital over time, you need to keep pace with inflation, which typically requires exposure to growth-oriented investments over longer time periods.
While the inflation rate generally applies to the broader economy, your personal inflation rate may be higher. When you look deeper into the details, you will see that inflation varies with a number of factors, from location to the differences between supply and demand for goods and services.
The figure below shows how the cost of some goods and services has risen much faster than others. Between 1989 and 2018, for example, the cost of college tuition and health care (hospital services, medical care and drugs) has greatly outpaced inflation. Many retirees face substantial health care costs and also may want to fund college for grandchildren.[ii]
Source: FactSet, as of 01/10/2019. Consumer Price Index data from 12/31/1990 - 11/30/2018.
These particulars affect each individual differently. They will likely continue to change over time, as some services will likely be in greater demand than others through the stages of an individual’s life. For instance, the cost of living will generally vary according to where you live. Living in a city incurs different costs than living in a rural area; but different cities and different rural areas also vary in comparison. The costs of goods and services can differ greatly over all these areas and affect your overall expenses.
Time and longevity are also important factors. Retirees live for many years beyond retirement. If you rely heavily on hospital services, healthcare or education (such as putting a grandchild through college), then your personal inflation rate may be higher than the average annual percentage. Total inflation doesn’t measure personal costs of living.
Retirees tend to spend more on healthcare and hospital services than others. Therefore, they may feel this loss of purchasing power even more—and need to account for this potential effect when planning for retirement.
The figure below shows that healthcare expenses, as a percentage of net income, increase as people age. The percentage spent on healthcare from age 55 to 64 is 9%. That percentage increases to 13% after age 65.[iii]
Source: Bureau of Labor Statistics, Consumer Expenditure Survey 2016.
Your retirement income needs to be able to purchase more than you expect. To estimate your personal inflation rate, think of how much you are spending on different goods and services. Maybe a large percentage of your budget is spent on food and entertainment, or maybe you expect to pay more for health care. Knowing roughly how much you spend on certain areas can help you estimate what your personal inflation rate may be.
In addition to inflation, you need to make sure you have sufficient retirement income to last through your entire time horizon. With better healthcare and medical innovations, people are living longer. This means you and your spouse may have a longer time horizon to plan for. Investment time horizon refers to how long you want your retirement savings to provide for you, your spouse and potential heirs. A longer time horizon could amplify the cost of inflation over time.
Average life expectancies may be a good place to start, but averages aren’t predictive. You and your spouse may live longer than the averages you see in life expectancy tables. And if you have a younger spouse or other dependents, you will need to account for their potential longevity. You don’t want them to run out of money when they need it most.
Most investors underestimate their investment time horizon and don’t plan for enough growth to accomplish their goals. They also overlook the impact of inflation. While time horizon and inflation may seem like minor factors, they can affect your ability to meet your investing goals over the longer term. If you don’t take these factors into consideration when planning for retirement, your portfolio could be less likely to cover your necessary expenses after you retire. And if you make this discovery 10 or 20 years down the road, you may not be able to do much about it. Think about these factors when crafting your plan and consider seeking the help of a trusted planner or adviser.
Planning for retirement and managing your savings after you retire are important and necessary. If you aren’t sure where to start or what retirement planning strategy is best for you, our financial advisers can assist you. Contact us and we will be happy to discuss your retirement income goals.
[i] FactSet, as of 2/12/2018. Based on US BLS Consumer Price Index from 12/31/1925 to 12/31/2017, average annualized inflation was 2.91%.
[ii] FactSet, as of 01/10/2019. Consumer Price Index data from 12/31/1990 – 12/31/2018.
[iii] Bureau of Labor Statistics, Consumer Expenditure Survey 2016.