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Prepare to Outrun Inflation in Retirement

When chased by inflation, you can run but you can’t hide. The need to outpace inflation, which diminishes investment returns and buying power, is especially acute for retirement investors.

Older Americans endure a higher rate of inflation than their urban counterparts, according to the Bureau of Labor Statistics (BLS). In addition to its widely quoted Consumer Price Index for All Urban Consumers (CPI-U), the BLS calculates a separate price index for Americans 62 years of age or older called the Consumer Price Index for the elderly (CPI-E). From December 1982 to December 2011, the CPI-E climbed 142.8% compared to a 131.2% increase for the CPI-U. One of the reasons for the disparity is the higher portion of their budgets older Americans allocate to medical care, which has historically increased more rapidly than other goods and services.

Therefore, the impact of inflation is a significant hurdle when trying to achieve long-term financial goals over the course of a retirement lasting anywhere from 20 to 40 years. Inflation has a negative compounding effect on savings, so even small amounts of unexpected inflation can substantially reduce buying power over time. If the historical long-term average inflation rate of 3.22% held steady, the price of goods would double after 21 years. Imagine if you plan on living off of an annual budget of $50,000 in retirement. The same style of living, assuming a 3% inflation rate, would cost $67,000 in 10 years and $90,000 in 20 years.

This is why the cumulative effects of inflation are so potentially devastating to your planned standard of living in retirement. Here are a few things that can help you stay a step ahead.

Hedging inflation in a portfolio

Long-term investors should hold asset classes that have expected real returns greater than inflation. Similar to taxes and fund fees, inflation acts like another investment cost. If an investment produces a return of 5%, the real return after adjusting for a 3% inflation rate is just 2%.

Inflation risk dispels the notion that money can be better protected during retirement by simply keeping your savings in low-risk asset classes, such as cash or cash equivalent investments. Their low yields, after adjusting for inflation, may not provide the growth needed for your retirement expenses, or a positive return at all.

Instead, to help hedge against inflation, retirement investors should look to have a portfolio that:

  • Holds an appropriate allocation of stocks. While retirees may be more risk averse, stocks can be effective engines of growth in the long run. In general, stocks have expected returns higher than other asset classes, albeit with more risk.
  • Includes Treasury inflation-protected securities (TIPS). A type of bond, TIPS produce returns that are linked to inflation.
  • Is broadly diversified. Spreading your assets across multiple uncorrelated asset classes, from small/value and international stocks to high-yield corporate bonds, can help minimize risk while potentially adding to the overall portfolio return.
  • Is filled with low-cost funds. While investors can’t control how big of a chunk inflation takes out of their returns, they can control something else that also eats away at returns – costs. With low-cost funds, investors retain a greater share of returns.

While index funds, which try to track a market index, don’t guarantee a return above inflation, the steps that can be taken to outpace it as outlined above make a strong case for them in a portfolio. They are generally broadly diversified and, most importantly, low cost. Plus, active funds tend to fall short of the indices they are attempting to beat. According the year-end 2013 S&P Indices Versus Active scorecard, over three and five-year time periods “the majority of the active managers across all the domestic equities categories failed to deliver returns higher than their respective benchmarks.”

Also, some advisers swear by commodities, especially gold, as an effective means to protect against inflation in a portfolio. While they have shown the ability to hedge inflation at times, there are reasons why long-term investors may be better off avoiding them. For one, their prices tend to be highly volatile, as they are speculated by traders. Additionally, they do not generate cash flows like traditional financial assets, some of which can also provide inflation protection.

Implications for your other income streams

Since retirees have a variety of income sources, understanding the corrosive effects of inflation on those outside of an investment portfolio can help plot a potential escape. For instance, if you consider purchasing an annuity for the guaranteed income payments, remember they may not be adjusted for increases in inflation rates. An annuity indexed to the CPI typically charges a higher premium.

Social security, a primary source of income for many retirees, does maintain a cost-of-living-adjustment for inflation. However, the means by which that is calculated is vulnerable to reform, which could reduce social security benefits in the future.

A boost from flexible spending habits

Retirement living consists of fixed and discretionary expenses. Fixed expenses are necessities, from shelter to food; discretionary expenses are things like travel, yoga classes, etc. To cover expenses as prices for both invariably increase over time, it is important to have a withdrawal rate from your savings that accounts for inflation.

For example, if you start with a $1 million portfolio and need 4% annually, then your initial withdrawal is $40,000. The following year, assuming a 3% inflation rate, that withdrawal would rise to $41,200, and would subsequently increase each year. This again emphasizes the need for growth in your portfolio as well as signifies the benefits of flexible spending habits, especially during periods of a down market. In the face of decreasing buying power from inflation, being open to making budget adjustments can help increase the longevity of retirement savings.

In the race to your financial goals, you won’t avoid inflation in retirement, but you can get a good head start.