Journey Into Retirement

INFLATION IS THE BIG CHEST-POUNDING GORILLA IN THE ROOM WHEN IT COMES TO RETIREMENT FINANCES

It’s a little like wrestling a gorilla. You don’t quit when you’re tired – you quit when the gorilla is tired.

Robert Strauss – American Politician & Diplomat

When it comes to retirement financial planning, there are several big gorillas in the room that you must wrestle. But, perhaps one of the biggest is the impact of inflation on your finances. What is problematic about inflation is that year-to-year it looks like a relatively small number. The average inflation rate over the last 50 years has been about 4.0% (3.4% if you exclude some abnormally high years in the 1970’s and 1980’s). It has been only 2.4% over the past 10 years. None of these percentages look particularly high. However, it is the cumulative effect over time that can sneak up on a retiree and play havoc with retirement finances.

Inflation can have two particularly damaging effects on retirement finances. First and perhaps most obvious is that it erodes buying power over time. Each year the cost to maintain your lifestyle edges up. After a 20 or 30 year retirement, these changes can be substantial. The second effect is that the inflation rate has a direct influence on the length of time your retirement savings will last. Let’s take a look at each of these in more detail.

Inflation Erodes Buying Power – BIG TIME

Let’s say, for example, that when you enter retirement you need $50,000 per year to sustain your pre-retirement standard-of-living. Let’s assume also that inflation is at the historic average of 4.0% each year. How does this affect your buying power? After 10 years of retirement, you would need $71,166, a 42% increase in annual income required to maintain your pre-retirement standard-of-living. After 20 years, this would grow to $105,342, an increase of 111% or more than double the beginning income requirement. After 30 years in retirement, your annual income requirement would balloon to $155,933, a whopping 212% increase from where you began. This is more than triple the original requirement. So, what appears to be a small increase from year-to-year can accumulate to a very big number over the course of a retirement.

Inflation Affects How Fast Your Retirement Savings Will Deplete

In retirement, you have sources of monthly income such as Social Security and possibly a pension and earnings from a job. However, whatever expenses are not covered by these sources must be made up by withdrawals from your retirement savings. The rate of inflation will affect what you must withdraw to maintain your standard-of-living. As inflation increases, the amount you will need to withdraw to maintain your standard-of-living increases. What this means is that inflation will have a direct effect on how long your retirement savings will last.

I used the Retirement Funds Longevity Calculator that you can download from the tools tab on this blog to illustrate this point. This calculator allows you to determine how long your savings will last given your retirement income, your savings balance when you enter retirement, the annual investment returns on your saving, and inflation. I assumed, for this example, that you were getting $15,000 per year from Social Security (the average in 2012), an annual pension of $10,000, had $500,000 in savings, and could expect an annualized investment return of 5% on your savings balance. I held those assumptions constant and calculated how many years your savings would last if inflation averaged 1%, 3%, or 5% over the course of a retirement.

How did the inflation rate affect the savings balance? Well, if inflation averaged 1%, your savings would last more than 35 years before the balance reached zero. With a 3% average inflation rate, your savings would be gone in 23 years. However, with a 5% annual inflation rate, your savings would last only 18 years. So, inflation really does have a significant impact on your retirement finances. Note that the exact numbers will vary according to the specific income and savings assumption you use. However, the relative changes are what is important.

To use my primate analogy, what seemed like a baby chimpanzee at the beginning of retirement could become a full-grown, chest-pounding gorilla by the end. There is probably no way to tame the beast. However, you should make sure that inflation is incorporated into your retirement planning and any financial assessments you make. Don’t ignore this. Your retirement financial security depends on it!

NOTE: You are welcome to download the tools in the tools tab above. These will help you assess your own retirement financial situation. The Amazon Kindle book in the book tab above helps you develop your own personal profile and provides detailed instruction on how to use the tools to make your personal retirement financial assessment. The tools are free. The book is a $3.99 investment in your retirement financial success.