How will today's high inflation impact my retirement?
I’m about 10 years away from retirement and am concerned about inflation and whether it means I’ll run out of money during retirement or if I’ll need to postpone retirement. I have a little over a million dollars in retirement funds and Social Security is a little less than half of what I’ll need each month in retirement.
Joshua Escalante Troesh, CFP
Inflation is definitely a concern, and the media frenzy around current inflation likely isn’t helping ease your current fears. While you are right to be concerned about inflation, it doesn’t necessarily mean it will threaten your retirement plan, even if today’s inflation lasts longer than we first expected.
Inflation is surprisingly more dangerous than a market crash.
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.
A 1% increase in inflation expectation drops the percentage of ‘successful’ projections from 66.1% to 38.7%
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.
Inflation Vs. Social Security and other ‘Guaranteed’ Income
Your guaranteed income (Social Security, Pensions, and Annuities) will also be significantly impacted by inflation during retirement. 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.
We know even expected inflation will out-pace any rises in these sources, so inflation above expectation can place an enormous strain on the portfolio.
Using 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 further complicated by the difference between normal inflation and your personal inflation rate.
Healthcare is a good example of this. While healthcare as a category inflates at just under 2%, your personal experience will be healthcare inflation at closer to 5%. This is because your experience adds the increasing cost of healthcare on top of your personal increasing need for healthcare as you age.
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 from your portfolio. And this leaves less money to invest and compound, making the rest of your retirement projections inaccurate.