What Is Inflation Risk & How Does It Affect My Retirement Income?

In February 2022, inflation hit its highest level since 1982 (40 years prior). Inflation rose to 7.9%, and the worst part is that experts are saying it could go even higher! So, people are understandably getting very concerned about inflation. They are starting to ask questions like:

• What is inflation risk? 

• How does inflation impact my retirement plan? 

• Can I reduce or eliminate inflation risk? 

In this article, we’ll answer each of those questions for you. Then, you’ll be able to avoid this wealth drain in your own retirement plan.

By the way, if you’re also looking to avoid running out of money in retirement, be sure to watch our free video here.

What is inflation?

The Consumer Price Index (CPI) measures the change each month in prices paid by consumers in the U.S. The average rate of inflation has been around 3% historically, which means the price of goods and services goes up on average by around 3% each year. This results in the reduction of your money's purchasing power, so your money will be worth less in the future. The government can bring in new regulations to put downward pressure on inflation if needed, but it’s best not to count on this.

We know the “average” inflation rate, but in periods of rising inflation, these figures can be higher. For example, rising prices/annual inflation at 4%, just 1% higher, can cut purchasing power in half after 20 years. This is why fixed income investments, variable rate securities, and a wide range of other options can be used as part of your overall investment strategy. Safer products like treasury inflation protected securities and fixed annuities can balance out your portfolio to avoid too much risk. Investors can even seek an “inflation premium”, which is a minimum amount of required return in order to compensate for inflation risk. Bonds are a common form of fixed income securities that can also be helpful.

To offer a visual, below is a graph from the New York Times that shows us what inflation has been historically.

Did you know? Health care inflation has actually outpaced overall general inflation. This is why long-term care risk is one of the top 10 retirement planning risks that we also help you to avoid.

How does inflation impact my retirement plan? 

Most people know about market risk, and how you can lose money that you’ve invested in the stock market if it goes down. Stock prices can plummet unexpectedly and quickly, so investment returns are not guaranteed (to learn more about this, read our article “how to avoid market risk”). But, there is one risk that in some ways, can be considered even riskier than the stock market. That risk is the one which we are already talking about today, inflation risk (sometimes referred to as purchasing power risk).

You have to ask yourself if your money is “too safe”. Is your money sitting in a bank account or CD earning less than 3%? If so, then you’re effectively losing money every year by not keeping up with inflation. You are guaranteeing yourself a loss! So, this can be even riskier than the stock market, as the stock market does have the opportunity for positive returns above the average 3% inflation number.

Here are some current national average interest rates:

Checking Account - 0.03%

Savings Account - 0.06%

Money Market Account - 0.08%

CD (certificate of deposit) 1 year - 0.20%

CD (certificate of deposit) 3 years - 0.29%

CD (certificate of deposit) 5 years - 0.36%

High Yield Savings Account - 0.60%

Did you know? From 2000 to 2019, the real rate of return for the S&P 500 Index was less than 3%.

Let’s take a moment to consider what would happen if inflation stays at 4%, and you have $100,000 to retire with today. Your $100,000 would only buy you around $50,000 worth of goods in 20 years’ time. This is because 4% inflation will cut the purchasing power of your retirement savings in half after 20 years! So, protecting yourself against inflation risk will help to form the basis of having steady cash flows in retirement.

Don’t forget, if one of your big concerns is running out of money in retirement, then watch our free video here to help eliminate that risk.

Can I reduce or eliminate inflation risk?

As with all of our articles, we first help you to identify the retirement risk. Then, we’ll explain how we can help you reduce or eliminate that risk. Here are a few ways in which we could do that for inflation risk:

• You should include options in your retirement plan that are expected to outperform inflation. You can also do this WITHOUT risking your money to stock market losses.

• There are some retirement options that have inflation protection built in. You want to have as much INCREASING income in retirement as possible. This can be achieved whilst protecting your assets at the same time. 

• You should always be aiming to maximize your Social Security income benefits. Your benefits do generally adjust for cost-of-living expenses each year. There are several ways to maximize your benefits, so it’s crucial that you speak with a professional who can help you with this.

If you understand what inflation is and follow the above steps, you can take control of this risk in your own retirement plan. However, this is only one of the top 10 retirement planning risks. In our blog, you can read about those other risks and how to eliminate them all.

If you’d like to see how we can help put together your own personal plan to avoid inflation risk, then schedule a free retirement consultation today.