How to account for inflation in retirement planning

When you’re thinking about how to account for inflation in retirement planning, you may gravitate toward one of two extremes: feeling like retirement is a distant concern you don’t need to plan for now or feeling constantly worried about your savings.

Either way, it helps to pay attention to the Federal Reserve (Fed), which aims for an inflation rate of 2% to keep prices stable and support a healthy economy. While the Fed aims for 2%, you may want to use a slightly higher rate for retirement planning: Try a 3% annual inflation assumption to account for healthcare, daycare for your children or grandchildren, housing, food, family expenses and even your go-to charitable causes.

You could use this 3% annual inflation rate to stress-test your savings against a higher spending level. By being proactive about inflation risk in retirement, you could help preserve your purchasing power. Here’s what else to keep in mind.

Inflation risk is the possibility that rising prices will reduce your money’s purchasing power (how much you can buy with a given amount of money).

For example, if you have a family pet, prices for pet supplies increased 1.7% over the past year. Grocery staples such as rice, pasta and cornmeal rose 3.9%, according to the U.S. Bureau of Labor Statistics (BLS). Over time, these small expenses add up, and inflation risk can be particularly significant for retirees who need these funds to last a few decades.

To account for inflation in your retirement plan, it helps to understand how inflation is measured.

The BLS calculates inflation using the Consumer Price Index (CPI), which measures the average price change over time for everyday goods and services like food, gas, clothing and healthcare. The percentage change in the CPI over a specified period is used to measure the rate of inflation. So, comparing CPI data across different periods shows how much consumer prices have increased or decreased.

With a one-percentage-point cushion above the Fed’s 2% inflation goal, a 3% annual inflation assumption is a reasonable starting point for retirement planning.

However, as with any plan, your assumption may need to be adjusted later. Revisit it periodically with a financial advisor to stress-test your plan at different inflation rates.

Let’s say you have $50,000 in cash today. Here's what that $50,000 would be worth in today's purchasing power after 20 and 30 years at three different inflation rates:

At 3% inflation, your $50,000 in savings would have the purchasing power of approximately $27,677 after 20 years and $20,597 after 30 years.

Losing that much purchasing power is exactly why retirement projections need to account for rising prices rather than assuming today’s expenses and savings targets will remain steady.

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While there isn't a foolproof way to safeguard your lifetime savings against unpredictable inflation rates, you can take the following steps to help strategically reduce inflation risk and build resilience within your portfolio.

Whether you choose a 3% annual inflation rate to stress-test or another amount, a higher inflation rate means you'll need more money in your retirement nest egg to maintain the lifestyle for you and your loved ones.

Additionally, inflation doesn't affect every expense equally. Housing and food may experience different rates than transportation in the same year.

A budget can help uncover areas where you can cut back. Are you reading your magazines or just using them to hold plant seeds? Paying for a gym membership when you usually exercise at home? Spending on streaming services you never watch?

By carefully tracking spending and separating fixed costs (like housing) from variable expenses (like subscriptions), you can identify areas where you may want to be more disciplined or have wiggle room.

Inflation can also bring unexpected expenses. A solid emergency fund can provide a buffer, potentially preventing you from needing to dip into your long-term investments and disrupting their growth potential.

Best practices for your rainy day fund

Take a look at these tips and account options for your emergency savings.

Follow these emergency fund guidelines

Relying on traditional savings accounts may mean your money loses value over time due to inflation. Investing in assets that have the potential to outpace it can be a part of your long-term investing strategy.

• Stocks. Some industries can act as inflation hedges, and stocks of growth-oriented companies may provide returns that exceed inflation. 10-year annualized returns historically have beaten annual inflation rates, though there are some short-term risks due to volatility.
• Real estate. Property values and rent can appreciate over time, so investing in real estate can provide some inflation protection. You also can explore real estate investment trusts (REITs) for exposure to real estate without needing to purchase a home or rental property.
• Treasury Inflation-Protected Securities (TIPS) are U.S. Treasury securities designed to help protect against inflation. Their principal is adjusted based on changes in the CPI, which can help preserve purchasing power. However, TIPS still carry investment risks.
• Commodities. Some commodities, such as gold, tend to increase in price during periods of higher-than-expected inflation. However, commodity prices can be unpredictable and don’t always rise when inflation does.
• Alternative investments. Some investments, such as collectibles, may withstand inflation, though they tend to be riskier. Before investing, it's important to do your due diligence and understand your risk tolerance.

There's something else to think about as you review your investment strategies. If you have an IRA or an employer-sponsored retirement account like a 401(k), keep contributing to it regularly, ideally with a fixed percentage of your income.

Reducing what you put in, even for a short time, can decrease your growth potential, which can have a lasting impact on what you accumulate for retirement. Contributing a set percentage of your income rather than a fixed dollar amount, particularly if you get regular raises, can give your retirement savings some built-in inflation protection.

While saving is key, having a source of guaranteed income can help reduce the risk of running out of money in retirement. An annuity can provide a guaranteed income stream that supplements your savings, while an inflation-adjusted annuity allows incoming payments to increase based on your specified adjustment.

If you’re nearing retirement, it may be tempting to claim Social Security benefits as soon as you're eligible. But consider the financial advantages of waiting. For people born in 1960 or later, if you claim as early as age 62, you'll receive 70% of your full retirement benefit. Delaying until age 70, however, means your benefit will be 124% of your full benefit.

Factoring in this timing can give you a larger potential income base for future cost-of-living adjustments (COLAs) linked to inflation. Delaying your Social Security benefits may help combat some of inflation's impact on future purchasing power throughout your retirement.

Keep in mind that this approach means it's even more important to build other savings for retirement income so you're able to hold off on Social Security benefits.

Medical expenses can eat away at a significant portion of your retirement budget, and some healthcare costs may rise faster than overall inflation. While fine-tuning your retirement budget, account for premiums, deductibles, copayments, prescriptions and any needed specialists. And speak with your family ahead of time about caregiving needs because Medicare doesn’t generally cover long-term care costs.

If you're eligible for a health savings account (HSA), consider how it could fit into your retirement strategy. Unlike flexible spending accounts (FSAs), HSA funds generally roll over from year to year and can be used for qualified medical expenses.

Review your savings and prepare for changes in inflation. The Federal Reserve often adjusts interest rates to combat inflation, so rising interest rates can mean higher returns on savings accounts but make borrowing more expensive.

To compensate for inflation, steps may include:

• Saving more than you think you need to counter inflation.
• Minimizing or paying off debt that carries interest charges.
• Increasing stock holdings in your portfolio.
• Maintaining short-, medium- and long-term investment strategies that you can tweak when inflation is high.

Approaching your plans with flexibility also can help reduce other risks like sequence of returns risk and longevity risk, both of which can significantly impact your retirement savings.

If you find the investments don't align with your needs, goals and risk tolerance, you may need to adjust or rebalance your portfolio.

Inflation should be a key factor in your retirement planning, so it's important to keep it top of mind as you go through the process. A financial advisor can help you review and evaluate the potential impact of inflation on your future purchasing power and adjust your savings strategy accordingly. They also can provide tailored advice to help you build a more inflation-resistant portfolio.

With a plan that accounts for inflation and adjusts as your needs change, you can be better prepared to make your retirement savings last.