Inflation risk: What it is & how it might impact your retirement

As you work hard to provide solid financial ground for your family, inflation understandably can pose a worry. While some inflation—the gradual increase in the prices of goods and services over time—is expected and low levels generally are not harmful, inflation risk is something you should be aware of. It can have a significant impact on your long-term investments, budget and savings.

The good news is there are things you can do to protect your nest egg for both today and the future.

Prices generally are determined by supply and demand, and they go up when demand increases or supply falls. Depending on the cause, inflation is categorized as either "demand-pull" or "cost-push."

This might occur for many reasons, but the most common examples are:

• Demand-pull: Higher incomes, easy credit and lower unemployment lead to widespread increased purchasing and contribute to inflation because more of the population is in a position to demand goods and services.

• Cost-push: Goods and supplies are in stable demand, but the raw materials or labor needed for them are, for whatever reason, harder to come by. This pushes up the cost of a small supply, contributing to inflation.

The most popular way to measure inflation is by tracking increases in the consumer price index, or CPI. It's a sample of prices for some of the most common products and services a typical consumer purchases over the course of a year.

Specifically, the percentage price change of those most common consumer purchases from one year to the next is how government agencies and other organizations measure inflation.

"Purchasing power" describes how much you're able to buy with a given sum of money. Because inflation is an increase in prices, higher levels of inflation mean you are not able to buy as much for a given amount of money over time.

Normally, long-run inflation is fairly modest and doesn't cause much harm because you easily can plan around it. Since 1914, the average annual inflation rate in the United States has been just above 3%. However, it isn't always consistent. Annual inflation was persistently high and even reached double digits multiple times from 1973–1981, largely brought on by issues with global oil supply. Inflation surged again after the COVID-19 pandemic, tipping slightly over 8% in 2022. These levels of inflation over the course of several years can be devastating.

Inflationary risk works against you by reducing the value of your savings. Its effect is cumulative, and it works the opposite way from compound investment returns. If the purchasing power of your savings and investments fall too much, you'll no longer be able to reach your goals or afford the retirement lifestyle you had planned. The more time between now and your retirement, the greater inflation's impact will be.

It also can affect your portfolio.

• Bonds are particularly vulnerable to inflation risk. Because they often pay a fixed rate of interest, the value of interest payments falls. The price of your bonds will fall, too, because interest rates rise with inflation, so newer bonds will be more attractive to investors.
  
• Stocks tend to perform better over time but also may be affected by inflation in the short run as the Federal Reserve tries to slow the economy and investors get nervous.

Inflation can have an effect on other securities too. It's hard to predict just how each may be affected, so it's always important to maintain proper investment diversification that's in line with your risk tolerance. It's a good idea to review your your portfolio, including an evaluation of your risk tolerance, periodically with a financial advisor.

Let's say that you estimate now, based on your budget at today's prices, that you'll need $1 million to retire 15 years from now. To make it easy, we'll say inflation is averaging 4% a year for all 15 years, but keep in mind that in reality, it can fluctuate greatly. Next year, your $1 million would only stretch as far as $960,000 did when you first started saving because prices would have increased while your dollar sat unchanged. The year after that, it would be worth about $921,600. At the end of 15 years, when you plan to retire, your $1 million in retirement savings would be the equivalent of $542,000 compared to back when you first started saving.

If you ignore inflation and don't account for it in your savings strategy, you may not be financially prepared to retire when the time comes. The idea behind fighting inflation risk is for your money to grow as fast as—or faster—than inflation so you retain—or increase—your overall purchasing power.

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If you expect some level of inflation, you can work it into your financial plan and minimize its effects. Going back to the prior example, if you think inflation will be 4% per year over the next 15 years, then you can update your savings target. So, in order to have $1 million worth of today's purchasing power, you'd need to have $1.8 million in savings when you retire in 15 years.

Based on historical data, if you anticipate inflation will be 3%-4% per year and update your plan accordingly, you may be able to largely shield yourself from inflation risk.

However, inflation isn't steady and doesn't always play by historical rules. Unanticipated inflation is the difference between expected inflation and actual inflation, and its unpredictability can cause problems for your saved retirement dollars.

If you ignore inflation altogether, then all the inflation you experience is unanticipated. If you think inflation will be 4%, but it turns out to be 6%, then unanticipated inflation is 2%. Thinking of it this way can help you better envision how to plan to save extra for inflation risk.

Although it's important to think about inflation, it doesn't have to be scary as long as you account for it in your plan and take steps to protect yourself.

At a high level, the easiest thing you can do is make sure your target goals reflect sound inflation estimates. You also can think about inflation from the perspective of your budget. If you need $6,000 per month to retire in today's dollars, calculate what that amount would be based on your inflation estimate and the number of years until your retirement.

You also can address inflation risk in your investment plan. That means investing aggressively enough so you can expect your investments to provide long-term returns that outpace inflation. This is called a real rate of return, and it's partially why the classic retiree portfolio consists of 60% stock.

Specific investments, such as inflation-protected bonds, also can fight against inflation:

• Treasury inflation-protected securities are government bonds whose principal adjusts with changes in inflation, impacting the periodic interest payments you receive.
• I bonds are another form of government bond that provides inflation protection because their interest rate changes with inflation.

Retirement income that receives an annual cost-of-living adjustment can provide some protection against inflation. Social Security is the most common example. The purchasing power of your Social Security benefit should remain relatively stable over time, so ensuring you maximize your payment is a good inflation protection strategy. Employer-provided pensions and some annuities also provide inflation adjustments.

If you can reduce your spending, you can reduce your exposure to inflation. That may not be ideal, but it's effective. Consider cutting discretionary expenses where possible, especially on things that may not add much fulfillment to your life.

Stepping back from a busy life is a large part of retirement. However, many retirees find that part-time work brings a sense of satisfaction and purpose. It also can provide a good buffer against inflation. The income you receive from a part-time job can reduce the strain on your investments, allowing them to grow and stay ahead of inflation. Adding even a small amount of income from part-time work can provide a significant amount of inflation protection.

To reduce the effects of inflation on your financial security, make sure you include reasonable inflation estimates in your long-term plan. Consider how long-term inflation might affect your portfolio, and adjust your asset allocation or include inflation-protected investments if necessary.

If you need help assessing your inflation risk and identifying steps you can take to reduce it, contact a local Thrivent financial advisor. They can help you clarify your situation and develop a financial strategy you can feel confident about.