When we think about retirement expenses, healthcare and taxes usually top the list. There is, however, a quieter and more persistent threat that eats away at your nest egg: inflation. Since inflation is not as easy to track as the day-to-day swing of the stock market or home prices, it is often unseen and underappreciated. Since 2015, cumulative inflation has increased by 35.6%(1). In other words, $100 in 2015 now only buys $73 worth of goods. This is a 27% loss in purchasing power, even if your account balances look the same. For retirees, these losses can be even more dangerous as many retirees live on fixed incomes. Whether you are approaching retirement or already there, it’s important that your financial plan accounts for the impact of inflation.
One built-in buffer against inflation is Social Security. Every year, the Social Security Administration makes a cost-of-living adjustment (COLA)(2) to benefits based on the Consumer Price Index (CPI). The major components of CPI are housing, food and beverage costs, transportation, and medical care. It also includes cost of recreation, apparel, education, and a few other factors. CPI essentially tells you how much more it costs to live today than it did last year. As CPI goes up, so do Social Security payments. While this is helpful, the CPI-based increase isn’t always enough. Healthcare is the largest expense for many retirees, and the average cost of healthcare has gone up by over 6% per year since 2005(3). In fact, the average retiree is projected to pay about $174,500 in healthcare costs(4) over the course of their retirement, which is about double the cost from 20 years ago.
Furthermore, Social Security is just one aspect of income in retirement. Other income sources, like pensions and annuity payments, usually do not increase over time and thus lose spending power as years go on. Another issue I often see in retirement planning is around investment portfolios for folks in their 60s, 70s, and beyond. Conventional wisdom suggests that investment portfolios should get more conservative as someone gets older. I commonly hear that subtracting your age from 100, will give you the percentage of your portfolio that should be in stocks (e.g., a 70-year-old would have 30% in stocks). While I do think it’s practical to decrease investment risk over time, the risk of being TOO conservative is that investments won’t be able to keep up with inflation and withdrawals.
Historically, the rate of inflation is about 3.2%(1) (based on the average CPI from 1914 to 2024). While historical data on CDs is difficult to pinpoint, 1-year CD rates have averaged about 4.5% since 1967(6). These rates are skewed a bit higher by double-digit rates in the late 1970s and early 1980s. Bond funds have averaged about 5%(7) over that same time period, while the S&P 500 (a proxy for “the stock market”) has averaged about a 10.3% return since 1967(8). So, the real (accounting for inflation) return of CDs has been about 1.3%, bond funds about 1.8%, and stocks about 7.1% on average. With many retirees withdrawing 3-5% of their portfolios annually, it’s easy to see how one could lose ground with low inflation-adjusted returns. All this is not to say that conservative investments like CDs and bond funds don’t have a place in a retirement portfolio they absolutely do. It is important, however, to have at least a portion of your portfolio growing at a higher rate for down the road.
Inflation may not get as many headlines as market crashes or tax law changes, but over time, it can quietly erode your purchasing power and threaten even the best-laid retirement plans. The good news is, with thoughtful planning, you can manage this risk. With a well-diversified investment approach, smart withdrawal strategies, and periodic reviews of your income sources, there are ways to help your money keep pace with rising costs. If you’re unsure whether your current plan is built to withstand inflation over the long haul, it might be time for a check-in.
References: