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.
Understanding what causes inflation
Prices generally are determined by supply and demand, and they go up when demand increases or supply falls. Depending on the cause,
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.
How inflation is measured
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.
How inflation threatens your purchasing power
"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
How inflation risk could affect your retirement savings
Inflationary risk works against you by
It also can affect your portfolio.
Bondsare 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. Stockstend 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
Example: Inflation's impact on $1 million in savings
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.
Prepare for the risks to your retirement savings
What to know about anticipated vs. unanticipated inflation
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.
5 strategies to reduce inflation risk for your life savings
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.
1. Adjust your goals to account for inflation
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.
2. Consider inflation in your investment plan
You also can address
Specific investments, such as inflation-protected bonds, also can fight against inflation:
Treasury inflation-protected securitiesare government bonds whose principal adjusts with changes in inflation, impacting the periodic interest payments you receive. I bondsare another form of government bond that provides inflation protection because their interest rate changes with inflation.
3. Maximize your inflation-adjusted income sources
Retirement income that receives an annual cost-of-living adjustment can provide some protection against inflation.
4. Adjust your spending as necessary
If you can reduce your spending, you can reduce your exposure to inflation. That may not be ideal, but it's effective. Consider cutting
5. Supplement with part-time work
Stepping back from a busy life is a large part of retirement. However, many retirees find that
Get help anticipating inflation risks
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
If you need help assessing your inflation risk and identifying steps you can take to reduce it, contact a local