As I have discussed in previous posts, inflation in retirement can be the big gorilla in the room. Over the years, what may seem like minor levels of inflation can add up to a major problem as it kicks you expenses to a much higher level and rips into your retirement savings.
However, there are countervailing forces that can help you deal with the ravages of inflation. The first is that Social Security benefits are adjusted annually for inflation. So, annual benefits increases are designed to help you deal with inflation. The second are any investment returns that you receive from your retirement savings. The question that I want to address in this blog post is how investment returns can help to offset inflation.
Some of the tools that you can download from this blog will require you to estimate your expectations about the average inflation rate over the course of your retirement and the average investment return from you savings that you expect. How do these investment returns help you?
Investment Decisions Affect Returns
You can have some control over your investment returns by how you allocate your savings. There are several classes of investments such as stocks and bonds. You can aggressively allocate your savings to various classes or you can be relatively conservative. Aggressive allocations provide the potential for greater returns, but with more volatility. For example, if you had aggressive allocations of your investments prior to the 2008 crash you would have seen greater losses as the stock market collapsed. In theory, if you had maintained your aggressive posture the value of your investments would have rebounded more quickly.
If you were more conservative in your investments, you would not have seen as drastic a loss, but the rebound would have been much slower. So, aggressive investing can mean more upside, but also more downside risk. Conservative investing means that you have less upside, but also less downside risk – at least that is the theory.
The primary factor that determines how aggressively or conservatively you should handle your investments is psychological. It is called risk tolerance. I will do a blog post on this topic in the coming weeks. However, risk tolerance has to do with how much risk you are comfortable tolerating. If you have a high tolerance for investment risks, you will tend to be more aggressive in your allocations. In other words, if you have a “don’t worry, be happy” outlook on your investments, you will probably be more comfortable investing more aggressively. If you have a low tolerance for risk, you will tend to be more conservative. How you handle your investments will be an important determinant of the average gains you can expect.
How Do Investment Returns Offset Inflation
As I like to do when presented with such a cool intellectual question such as this is to do an analysis to find the answer. The exact analysis will vary according to your specific situation. However, I can provide you with some general guidelines about how investment returns offset inflation. I used the Retirement Funds Longevity Calculator tool that you can download from this blog. I developed a hypothetical example and varied the assumptions about average investment returns and inflation. Then, for each combination of investment return and inflation rate, I estimated how many years your savings would last. I then indexed all of these variations to how long your savings would last if your investment return equaled the inflation rate. This may sound a little complicated, but the table below should clarify this.
Again keep in mind that the specific results will vary according to your own situation, but you can get a felling for the relative differences. Also, put your own information into theRetirement Funds Longevity Calculator Tool and vary the assumptions about investment returns and inflation. This will provide the same information specific to your own situation:
Investment Will Savings
Return Inflation Last (Index) In the Example
1% 4% 77 Savings Last About 20 Years
2% 4% 81 Savings Last About 21 Years
3% 4% 88 Savings Last About 23 Years
4% 4% 100 Savings Last About 26 Years
5% 4% 112 Savings Last About 29 Years
6% 4% 117 Savings Last About 34 Years
What is this telling us? If your average investment returns and inflation both equaled 4%, your savings would be expectd to last about 26 years in the example. If however, your investment returns averaged 1% and inflation averaged 4%, your funds should last for only 20 years or only about 77% as long. If your investment returns averaged 6% and inflation averaged 4%, your savings should last about 17% longer or about 34 years in the example.
So, as my father used to say, what does this have to do with the price of tea in China? The answer is simple. How aggressive or conservative you are when you invest your savings following your retirement could directly affect how long your savings will last. This is not only because you are adding to your savings over time, but because it could serve as a partial offset to inflation. A more aggressive investment strategy will, in theory, help you better extend your funds although the volatility of the returns could be quite a rollercoaster ride. This also illustrates how well investment returns can offset the negative effects of inflation.
As you think about your investment strategy following retirement remember that there are costs and benefits to being too conservative or too aggressive. Factor this into your thinking as you plan for retirement.