How to think about inflation in retirement

 

Rising prices dent growth and pocketbooks, but not all cost pressures are the same. Inflation increases in certain areas impact different demographics in unique ways. More specifically, retirees feel some price increases to a greater degree than younger cohorts.

 

Having a customized and detailed analysis of inflation and expenses is a greater financial tool than just analyzing headline figures. Knowing which expenses matter and how price changes in those categories impact budgeting is valuable and often overlooked.

 

Also, seniors typically experience the negative aspects of inflation. Retirees (by definition) usually do not participate in the silver lining of high inflation, which is higher earnings gains. Wage growth is often a factor in overall inflation, but it also takes some of the sting out of higher prices for goods and services.

 

On a related note, many retirees have fixed-income portfolios. Fixed income pays out a fixed dollar amount, regardless of inflation. The higher the inflation, the greater the erosion of those bond interest payments' "real" value.

 

The cost-of-living adjustments baked into Social Security can be the only buffer against rising prices, which is why analyzing expense changes becomes important. What are a retiree’s basic needs and wants? How to think about risk? Are you willing to accept a lower standard of living?

Which cost changes typically matter most?

Below are some of the most common expense pressures that impact retirees the most:

 

• Health care inflation is often the most significant expense for many retirees. These costs also typically rise as people age, since long-term/specialized care (e.g., assisted living) becomes more prevalent.
• Home-related costs, taxes, and insurance are also important to monitor. Many retirees choose to age in place longer than prior generations (and current generations live longer, too). Those costs all increase over time, while income streams typically diminish in retirement. For example, housing costs within the CPI have averaged an annual increase of about 3.15% over the past 30 years compared to the overall average CPI increase of about 2.5% over the same period.
• Travel and leisure should be analyzed even though they are often discretionary, since younger retirees often take trips while they are still able. Many of these costs have historically been lower than the overall CPI increase. Still, they are discretionary and need attention to ensure they do not infringe on required capital for essential expenses.

 

The bullet points above are not a definitive list. The point is to start the process of thinking about what expenses will matter most as you age and making sure you have the assets to cover expenses.

How to think about investing.

Asset appreciation takes on a greater meaning in retirement since job-related income streams disappear.

 

Historically, stock market investments have often been a great way to protect against various inflation pressures. For example, the CPI has slightly more than doubled in the last 30 years while the S&P 500 has increased by more than 20 times (when dividends are reinvested).  In general, investments in assets that outperform inflation growth are valuable.

 

Since 1995, the S&P 500 has returned around 10.6% per year on average, while the CPI has increased about 2.5% per year on average. (On a real return basis, when discounting the increases in the CPI, the index has averaged an annual increase of 8.2%.) While the stock market has experienced bear markets over the years, its valuations still outperform inflation increases, often by a large degree.

 

History is not bound to repeat, but it is usually a good starting point for meaningful analysis. While equities have performed well over recent decades, they can be volatile over shorter increments. This can lead to heartburn and cause investors to lose sight of the long-term potential and opportunity. However, some forecasts call for weaker equity returns in the coming years. A diversified portfolio typically protects against equity volatility and potentially smaller equity valuations.

 

Retirement plans have noticed historical equity returns. U.S. retirement assets currently total more than $44 trillion. Of that total, the majority is invested in equities. Stocks are not the only inflation-pressure hedge. Bonds have also performed well as an investment metric, especially compared to the average inflation increase.

 

Solving this issue takes time, but starting to think about inflation pressures in retirement is the first important step.

 

SOURCES:

Morningstar Direct, YCharts, Crandall Pierce & Co., Federal Reserve Economic Data, Investment Company Institute.