Why do you need to consider inflation in your retirement planning?

What is inflation?

Inflation can be described as a rise in prices generally, which results in the gradual decrease in the value of our dollar. It is a natural process in the economy and a steadily rising inflation rate is normally associated with a growing economy. A good way to explain inflation is through the simple example.

Each morning, you buy a coffee for $2.00. With a 5% per year inflation rate, in theory your coffee should cost $2.10 the next year.

Some historical example:

In 1965:

·         A loaf of bread cost you 27 cents
·         A liter of milk was 31 cents
·        Gas for your car was about 40 cents /gallon
·        The average car cost was $2,500

In 2011:

·        That same loaf of bread was about $2.50
·        A liter of milk was about $2.60
·        Gas for your car was about $3.6 /gallon
·        The average new car was over $30,000

Why do you need to be aware of the effect of inflation?

When investing, it’s important to consider inflation, as it can diminish the real value of your money over time. When looking at investment returns, you should consider “real returns”, which calculate your asset’s value after inflation is taken into account. Let’s look at another example.

The interest rate on your savings account currently pays 5% per annum (the ‘nominal return’). If the annual inflation rate is currently at 3%, then the real return on your savings today would be 2% per year. That is, nominal return - inflation = real return, OR 5% - 3% = 2% real return. In other words, even though the nominal rate of return on your savings is 5%, the real value of your savings only increases by 2% over the year due to inflation.

As investors, we all aim to make profitable returns. However, we need to consider the effects of inflation because it means our returns must keep up with the rate of inflation in order to achieve a positive real return over the long term.

How inflation affects retirement savings?

You still see articles wondering if a million dollars will be enough for retirement. Increasingly, though, new generations should regard the premise that a million dollars is adequate for retirement as a quaint notion.

Given the historical average inflation rate of 3.75% a year, by the time a 25-year old today reaches 70 years of age, he would see inflation turn that million dollars into the equivalent of $190,781 in today’s dollars. All of a sudden, that doesn’t sound like such a lavish retirement nest egg, does it? Clearly, any retirement savings target has to factor in the effects of inflation over time.

First you need to estimate the inflation rate between now and the time you retire. So assuming you are 50 now that would be 15 years. If inflation is 3% per year (very optimistic suggestion) that means that next year your expenses would be $50,000 + ($50,000 x 3%) = $51,500 and the year after that it would be $51,500 + ($51,500 x 3%) = $53,045 and so on up until your retirement 15 years from now when you will require $77898 to buy the same things that you can buy today for $50,000. And that is if you know that inflation will be 3% per year. Which you don’t… it is a good long term average but during any given 15 year period it could be higher or it could be lower. Any retirement planning calculator can help you play with these numbers and get a good feel for what you will need several years from now based on various inflation rates.

The next problem is that inflation doesn’t stop when you retire, so in addition to needing enough income to cover the $77,898 /yr. that amount will continue to increase by the inflation rate as well. So assuming that you wanted to have a nest egg large enough to throw off $77,898, fifteen years from now and you figured you could earn 10% per year (an optimistic projection these days) you would need to have accumulated $778,980. Thus it would generate $778,980 x 10% = $77,898. But wait, what about inflation? In addition to the 10% your nest egg would have to generate an additional 3% to cover the inflation and enough to cover the taxes on the $77,898 plus the taxes on the imaginary gain to cover the inflation. Whew, and that’s not even taking into consideration things like what happens if you live longer than the average?

Now you see why estimating how much you will need during retirement is so complicated especially when inflation is factored into the calculation. Because there are so many variables, in reality the best you can do is estimate how much you will need and then add as healthy a cushion to that as possible. The one thing on the plus side is that so far we have assumed that you haven’t touched your nest egg. It is possible at some point, to dip into your nest egg to some extent as you get older (of course the income it generates will decline as well). This will affect the amount available for your heirs however. But that issue can be addressed through life insurance. You might also consider an annuity as part of your retirement plan, which can guarantee you a certain fixed amount per month for the rest of your life, no matter what the investment climate is.

Factoring inflation into a retirement savings plan

Here are some tips for factoring inflation into your retirement savings plan:

• At an average annual rate of 3.75%, inflation will double approximately every 19 years. Use this as a rule of thumb to figure out how many times your cost of living will double by the time you need the money.
• Don’t use your retirement date as the endpoint for your retirement planning. Remember, you could easily live another 20 years or more in retirement — time enough for your cost of living to double yet again.
• Inflation may vary greatly from year to year, but keep that 3.75% average in the back of your mind before locking in any certificates of deposit (CDs) or any other long-term investments. Also be sure to consider the impact of taxes. If you’re looking for a “safe” investment, it’s currently better to keep your bank deposits short and flexible — e.g., in a high-interest savings account or money market account — until bank rates recover.
• In the long run, you’ll need to consider investing more aggressively to protect your nest egg against the devastating effects of inflation. Without the higher returns offered by stocks and bonds, it will be virtually impossible to outpace inflation.

Because of the compounding effect of inflation over time, failing to account for inflation in your retirement savings plan can be as devastating as losing more than half of your money. However, if you get an early start and make sensible investments, you can get the power of compound interest rates working for you rather than against you.

Additional ways to add inflation protection to your retirement plan

Social Security provides important inflation protection. It’s one of the few retirement benefits around with a built-in cost-of-living adjustment (COLA), which is made using a formula set by federal law. Working at least until your Normal Retirement Age (currently 67) boosts your odds of receiving higher lifetime payments, and you’ll receive all the COLA adjustments from the intervening years.

Model your retirement portfolio to allow for an annual withdrawal rate of 3.75 to 4%, plus an additional bump for inflation starting in year two of retirement. Adjust that plan only if necessary to preserve assets in the event of a severe bear market.

An income annuity can protect against inflation if you purchase one with a cost-of-living feature that provides automatic increases in payments indexed to inflation. I like income annuities — otherwise known as Single Premium Income Annuities — as a way to assure that you can meet all your living expenses in retirement. Here’s a good way to think about it: Start with your total monthly expenses, and subtract your expected Social Security and any other guaranteed income source, such as a defined benefit pension. The gap amount is what you could fill with an inflation-indexed income annuity.

Long-term care insurance should be purchased with a feature that adjusts daily benefit payments annually to protect against escalating nursing care costs. An annual 5% compound growth option is typical, and can boost the benefit value of a long-term care policy significantly over time. The American Association for Long-Term Care Insurance calculates that a policy bought in 1995 by a 55-year-old couple with a $150 daily benefit amount and a 5% compound growth option would grow to a $508 daily benefit by 2020, when they’re both 80 years old.

If you’re several years away from retirement, or you are already in retirement and need to create a bucket for potential expenses some 10 years from now, consider a variable annuity with a guaranteed accumulation rider. This type of rider guarantees that the minimum amount received by the annuitant after the accumulation period, or a set period of time, is either the amount invested or is locked in gain. This rider, in essence, protects you from market fluctuations.

Delay Social Security

And finally, one of the best ways to address the risk of inflation is to delay your Social Security, if possible, till age 70. Doing so, experts suggest, will give you the highest possible, inflation-adjusted, guaranteed stream of income possible from Social Security. Depending on your age, you could increase your annual benefit up to 8% percent per.

Sources and Additional Information:

http://www.fivecentnickel.com/2010/01/20/what-inflation-will-do-to-your-retirement-savings/

http://inflationdata.com/articles/2013/02/02/inflation-retirement-planning/

http://www.foxbusiness.com/personal-finance/2011/03/25/4-ways-add-inflation-protection-retirement-plan-815187935/

http://www.russell.com/AU/_pdfs/investor-edu-comms/investor-toolkit/R_NEWS_Toolkit_Inflation_V1F_0906.pdf

http://www.marketwatch.com/story/how-to-deal-with-inflation-risk-in-retirement-2011-03-07

Attachment A (http://www.usinflationcalculator.com/inflation/historical-inflation-rates/)

Table of Historical Inflation Rates by Year (1914-2013)

Year	Inflation
1914	1.0
1915	1.0
1916	7.9
1917	17.4
1918	18.0
1919	14.6
1920	15.6
1921	-10.5
1922	-6.1
1923	1.8
1924	0.0
1925	2.3
1926	1.1
1927	-1.7
1928	-1.7
1929	0.0
1930	-2.3
1931	-9.0
1932	-9.9
1933	-5.1
1934	3.1
1935	2.2
1936	1.5
1937	3.6
1938	-2.1
1939	-1.4
1940	0.7
1941	5.0
1942	10.9
1943	6.1
1944	1.7
1945	2.3
1946	8.3
1947	14.4
1948	8.1
1949	-1.2
1950	1.3
1951	7.9
1952	1.9
1953	0.8
1954	0.7
1955	-0.4
1956	1.5
1957	3.3
1958	2.8
1959	0.7
1960	1.7
1961	1.0
1962	1.0
1963	1.3
1964	1.3
1965	1.6
1966	2.9
1967	3.1
1968	4.2
1969	5.5
1970	5.7
1971	4.4
1972	3.2
1973	6.2
1974	11.0
1975	9.1
1976	5.8
1977	6.5
1978	7.6
1979	11.3
1980	13.5
1981	10.3
1982	6.2
1983	3.2
1984	4.3
1985	3.6
1986	1.9
1987	3.6
1988	4.1
1989	4.8
1990	5.4
1991	4.2
1992	3.0
1993	3.0
1994	2.6
1995	2.8
1996	3.0
1997	2.3
1998	1.6
1999	2.2
2000	3.4
2001	2.8
2002	1.6
2003	2.3
2004	2.7
2005	3.4
2006	3.2
2007	2.8
2008	3.8
2009	-0.4
2010	1.6
2011	3.2
2012	2.1