How Does Inflation Impact Current Retirees’ Portfolios?

by | Nov 29, 2021 | Financial Planning

The current inflationary environment can have a scary impact on your retirement plan. Retirees often worry that prices will outpace their asset growth or their income from Social Security and pensions. But don’t worry, there are steps that retirees can take to deal with the impact of inflation on their retirement plans.

Where does inflation currently stand?

In September, the Consumer Price Index [CPI], a common measure of inflation, increased an additional 0.4% bringing the 12-month increase to 5.4%. According to the Bureau of Labor statistics, inflation only reached that level twice in the past 30 years—in January 1991 and July 2008.

Members of the Federal Open Market Committee [FOMC] predict that inflation will remain above the Federal Reserve’s target of 2% through at least 2024. Fed Chair Jerome Powell has said repeatedly that the spike in inflation will be temporary and is driven by pandemic-related supply chain bottlenecks. While the current spike in inflation may prove to be transitory, inflation can have a significant impact on the day-to-day lives of Americans, especially those in retirement.

When prices for goods and services increase, purchasing power decreases. For those on a fixed income, this can mean that they can no longer afford the lifestyle they are accustomed to living. For example, at a 3% annual inflation rate, a person who retires at 62 will lose 22% of their purchasing power by age 70 and more than 50% by age 85 – if their income does not increase along with inflation.

Impact of Inflation on Income from Pensions and Social Security

Income during retirement can come from a variety of sources. Most commonly, retirees receive income from Social Security, and their retirement benefits accumulated from prior employment. Those benefits, such as 401(k)s and pensions, can vary from one employer to another. Most retirees have multiple sources of income. In fact, according to the Pension Rights Center,  84% of retirees receive Social Security, 68% receive income from assets like 401(k)s or IRAs, and 31% receive income from pensions.

Income from Social Security is adjusted each year for inflation based on the movement in the CPI. There are two main factors for concern when talking about Cost-of-Living Adjustments [COLAs] and Social Security. Benefit increases from Social Security become effective in January of each year based on the increase in inflation during the previous year.

For example, the COLA for 2022 is based on price increases from the third quarter 2020 through the third quarter 2021. This means that benefit increases can lag behind prices – by up to 15 months. During the months where inflation increases but benefits remain level, retirees must compensate for their lost purchasing power. This situation often results in the need to reduce expenditures or withdraw more from savings.

The second concern is that COLAs are based on price increases experienced by urban workers, measured by the CPI-W. Spending habits of retirees are different than those who are still working. Retirees tend to spend less on goods, apparel, transportation, and recreation than working adults, but retirees tend to spend more on housing and medical care – two of the sectors that have recently experienced high inflation. Based on data from the BLS, prices for the goods that retirees buy have increased 124% since 1990 compared to 114% for the goods that working adults purchase.

The same issues apply for those who receive pensions. Most private pensions do not increase benefits based on inflation, and only 75% of pensions sponsored by state and local governments have COLAs. For those public pensions that do increase benefits based on inflation, roughly half increase benefits automatically based on CPI data, but these are commonly capped at 3%. These increases are implemented after inflation has been recorded, meaning that there is often a gap between when prices increase and when pension benefits follow. The 3% cap can also cause benefits to lag behind inflation, as will be seen by many individuals in 2022 when inflation may exceed the capped increase.

Impact of Inflation on Income from Retirement Account Assets

Most retirement assets in a 401(k) or IRA are invested in stocks, mutual funds, or bonds. Some specialized bonds are inflation adjusted, but in general, these types are investments aren’t protected against inflation.

Globally since 1950, short term securities have averaged 0.88% annual return, bonds have averaged 2.79% and equities have averaged 8.3%. While equities have yielded impressive rates of return over the past 70 years, researchers have found that equity returns have a negative correlation with inflation. In periods of high inflation, equity returns are lower. Debt assets such as short-term securities and bonds tend to increase their yields when inflation is high. Even when yields increase, total earnings may not be enough to maintain purchasing power.

What can you do to minimize the impact of inflation?

Historically, a balanced portfolio has outpaced inflation in the long run. A balanced portfolio includes an optimized mix of equities, bonds, and short-term investments. Equities provide portfolio growth while bonds provide income.

Many investors are concerned with the current level of inflation and how it will impact their lifestyle in the coming years. There are a few things that retirees can do to minimize the impact of inflation on their income during retirement.

Plan for it

The most important thing you can do to make sure that your financial plan can withstand inflation is to build inflation into your plan. Anticipating future price increases can help you accurately predict how much income you will need in the future and not overspend today.

Optimize your portfolio

Ensure that you are getting the most income from your investments without taking on unnecessary risk. Some investments, like cash, may not keep pace with inflation. A balanced portfolio tailored to your risk tolerance may help your nest egg keep pace with or outpace inflation.

Talk with an Experienced Financial Professional at Brookstone Wealth Management

If you are concerned about how inflation will affect your retirement plan, contact an advisor at Brookstone Wealth Management. We have a process to develop your Financial Fingerprint™ – a financial plan that is quick to assemble, easy to understand, and simple to modify as circumstances change.

This plan and continued support from our experienced team of financial and legal professionals can help you reach your retirement goals. To get started, contact us today.