Inflation has been all over the news the last couple years. In 2021, the annual inflation rate was 7% – the highest it had been since 1981. In 2022, it dropped a little bit to 6.5% – still well above the average inflation rate of 3.8%.
Now here we are kicking off Q2 2023, and the inflation rate seems to be continuing on a downward trend, with the first three months turning in 6.4%, 6% and 5% inflation rates, respectively.
We’ve all felt the effects of inflation in our daily lives, from the gas station to the grocery store. But what about the bigger picture? What impact does inflation have on something like your retirement accounts?
What Exactly is Inflation?
The inflation rate represents the decreasing buying power of a dollar. The annual inflation rate in 2021 was 7%, so by the end of the year, one dollar was the equivalent of 93 cents a year earlier.
That kind of rapid weakening of a dollar can have a major impact on financial plans that were built with an assumption that inflation would continue at the usual pace.
Inflation can Have a Dramatic Impact on Your Retirement
No doubt about it, retirees have been feeling the effects of inflation. In 2022, 1 out of 5 retirees said they anticipated having to get a job again to combat the impact of inflation on their retirement plan.
The main concern is that inflation decreases your purchasing power, which means everything will cost more. While you may have planned to live off an annual income of $50,000 in retirement, suddenly a 7% inflation rate drops the value of that income to $46,500. That may not seem like much, but a drop that big can have a rippling effect on the rest of your plan.
Severe spikes in inflation can be especially hard on people in the “fragile decade” – the last five working years and the first five years in retirement. Large-scale financial changes during this period of your life can have an outsized impact on the health of your retirement plan due to something advisors call “sequence of returns risk.” In short, if your portfolio dips at the beginning of your retirement, you will have less time to make up the difference than you had earlier in life.
How Does Inflation Affect Different Retirement Accounts?
Inflation can have different effects on different accounts. For instance, Social Security is subject to an annual Cost of Living Adjustment (COLA), but it doesn’t always keep up with inflation. For instance, in 2021, the COLA was 5.9%, but as we said, the inflation rate was 7%. To be fair, they tried to make it up the following year by implementing a COLA of 8.7%, the largest increase in 40 years.
Other investment account types (401(k), Roth IRA, etc.) do not adjust for inflation. That being said, the amount you can contribute to different accounts often increases during times of inflation. This year, you can contribute $22,500 to your 401(k) and $6,500 to your Roth IRA, up from their respective amounts of $20,500 and $6,000 last year.
What can retirees do to protect themselves from the effects of inflation? Here are five tips:
5 Ways Retirees can Protect Themselves from Inflation
1. Avoid holding excess cash
People will often park their money in cash thinking of it as a safe way to avoid market risk, but if you won’t be using the money in the short term you are actually exposing yourself to inflation risk because that cash will be losing purchasing power over time as inflation works to increase prices, but not the value of your account
2. Make sure your investment portfolio is designed with inflation in mind
This means you’re going to want to have some equity exposure. A diversified equity allocation is going to be one of the best hedges against inflation. On the fixed income side, inflation protected securities can also help to buffer your plan against inflation. In addition, be very cautious about locking yourself into long term or illiquid investment options, for example annuities, which may guarantee a stream of fixed income, but if your payment stays constant and inflation continues, your purchasing power will be going down over time.
3. Understand your budget
Everyone has two types of budgets: comfortable and tight. Look back over your budget to see where you could save money each month.
4. Use cash and minimize withdrawals from investment accounts
While you’re saving money by downsizing and redoing your budget, make that cash you’re saving stretch as far as you can. The more money you can leave in the market, the better chance it will have of bouncing back when things turn around.
5. Meet with your financial advisor
Your financial advisor can provide a neutral, professional perspective on your plan, which can help calm your nerves and keep you from making rash decisions. Let them know you would like to sit down and go over your plan again with them – that’s what they’re there for!
Want to Talk About Your Retirement Plan?
At Clarity, we help our clients create retirement plans that are built for real life. We’d love to sit down and discuss your plan for the future. Click here to reach out today.