How Does Inflation Affect Retirement?

By Paulina Likos · March 01, 2024 · 7 minute read

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How Does Inflation Affect Retirement?

For retirees on a fixed income, inflation can have a significant influence on their ability to maintain their budget. That’s because as inflation rises over time, that fixed income will lose value.

That could mean that retirees need to scale back their spending or even make drastic changes to ensure that they don’t run out of money. The average rate of inflation was 8% in 2022, the highest inflation rate in 40 years. By January 2024, the inflation rate had dropped to 3.1%.

When it comes to their retirement money, 90% of Americans ages 60 to 65 say inflation is their biggest concern, according to a 2023 survey by Nationwide. However, by planning ahead, it is possible to minimize some of the impact of inflation on your nest egg.

Read on to learn more about inflation and retirement and what you can do to help protect your savings.

What Is Inflation?

Inflation is the rate at which prices of goods and services increase in an economy over a period of time. This can include daily costs of living such as gas for your car, groceries, home expenses, medical care, and transportation. Inflation may occur in specific segments of the economy or across all segments at once.

There are multiple causes for inflation but economists typically recognize that inflation occurs when demand for goods and services exceeds supply. In an expanding economy where more consumers are spending more money, there tends to be higher demand for products or services which can exceed its supply, putting upward pressure on prices.

When inflation increases, the purchasing power of money, or its value, decreases. This means as the price of things in the economy goes up, the number of units of goods or services consumers can buy goes down.

How does inflation affect retirement? When purchasing power declines, the value of your savings and investments goes down. While the dollar amount does not change, the amount of goods or services those dollars can buy falls. In retirement, inflation can be especially harmful, since retirees typically don’t have an income that goes up over time.

Concerns about inflation and retirement may even push back the age at which some people think they can afford to retire.

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5 Ways that Could Potentially Minimize the Impact of Inflation on Retirement

While inflation can seem like a challenging or even scary part of retirement, there are several investment opportunities that may help you maintain purchasing power and reduce the risk of inflation.

1. Invest in the Stock Market

Investing in stocks is one way to potentially fight inflation. A diversified portfolio that includes equities may generate long-term returns that are higher than long-term inflation. While past performance does not guarantee future returns, over the past 10 years, the average annualized return for the S&P 500 has been 12.39%. Even when inflation is factored in, investors still have substantial returns when investing in stocks. When adjusted for inflation, the average annualized return over the past 10 years is 9.48%.

However, stocks are risk assets, which means they are sensitive to market volatility. These price swings may not feel comfortable to investors who are in retirement so retirees tend to allocate a smaller portion of their portfolio to stocks to help manage market risk.

How much you may decide to allocate to stocks depends on a number of factors such as your risk tolerance and other sources of income.

2. Use Tax-Advantaged Retirement Vehicles

To maximize the amount of savings you have by the time you reach retirement, start investing as early as you can in young adulthood in retirement accounts such as employer-sponsored 401(k)s or Individual Retirement Accounts (IRA). The more time your money has to grow, the better.

With 401(k)s and traditional IRAs, the money in them grows tax-deferred; you pay income tax on withdrawals in retirement, when you might be in a lower tax bracket than you were during your working years.

Another option is a Roth IRA. With this type of IRA, you pay taxes on the money you contribute, and then you can withdraw it tax-free in retirement.

Recommended: How to Open an IRA

3. Do Not Over-Allocate Long-Term Investments With a Low Rate of Return

Risk averse investors may be tempted to keep their nest egg invested in securities that are not subject to major price swings, or even to keep their money in a savings account. However, theoretically, the lower the risk investors take, the lower the reward may be. When factoring in fees and inflation, ultra-conservative investments may only break even or perhaps lose value over time.

While they offer a guaranteed return, high-yield savings accounts, for example, typically don’t earn enough interest to beat inflation in the long run. Since savings account rates are not higher than inflation rates, the buying power of your savings will continue to decline. That’s particularly important for retirees who are often living off their savings and investments, rather than off of an income that rises with inflation.

Because of this, retirees may want to consider keeping a portion of their investments in the stock market.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

4. Make Sure You Understand Inflation-Protected Securities

Treasury inflation-protected securities or TIPS, which are backed by the federal government, are designed to help protect investments against inflation. The principal value of the investment increases when inflation goes up and if there’s deflation, the principal adjusts lower per the Consumer Price Index.

However, for some investors, TIPS may have disadvantages. TIPS typically pay lower interest rates than other government or corporate securities. That generally makes them less than ideal for individuals like retirees who are looking for investment income. Also, unless inflation is quite high, and unless they are held for the long-term, TIPS may not offer much inflation-protection. There are also potential tax consequences to consider when the bonds are sold or reach maturity.

Finally, because they are more sensitive to interest rate fluctuation than other bonds, if an investor sells TIPS before they reach maturity, that individual could potentially lose money depending on the interest rates at the time.

Be sure to carefully weigh all the pros and cons of TIPS to decide if they make sense for your portfolio.

5. Buy Real Estate or Invest in REITs

Retirees may also consider investing in real assets. Real estate is typically an inflation hedge because it holds intrinsic value. During periods of inflation, real estate may not only be able to preserve its value, but it might also increase in value. One of the daily costs impacted by inflation is the cost of housing.

That’s why rental income from real estate historically has kept up with inflation. Investing in real estate investment trusts (REITs), may be another way for retirees to diversify their investment portfolio, reduce volatility, and add to their fixed-income. Just be sure to understand the potential risks involved in these investments.

Inflation Calculator for Retirement

It’s important to factor inflation into your plans as you’re saving for retirement. One way to do that is using a retirement calculator, like this one from the Department of Labor, which accounts for how inflation will impact your purchasing power in the future. That calculator uses a 3% inflation rate for retirement planning, but inflation fluctuates and could be higher or lower in any given year.

The Takeaway

While inflation can have an impact on a retirement portfolio, there are ways to protect the purchasing power of your money over time. Allocating a portion of your portfolio to stocks and other investments aimed at minimizing the impact of inflation may help.

Another way to curb the impact of inflation during retirement is to reduce expenses, which allows the money that you have to go further.

And starting to save for retirement as early as possible could help you accrue the compounded returns necessary to counteract rising prices in the future.

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Is inflation good or bad for retirees?

A small amount of inflation each year is a normal part of the economic cycle. But over time, inflation eats away at the value of the dollar and purchasing power of your nest egg is diminished. This can have a negative effect on a retirement investment portfolio or savings.

How can I protect my retirement savings from inflation?

There are several Investing strategies you can use to protect retirement savings from inflation. These include diversifying your portfolio with inflation hedges including TIPS (treasury inflation-protected securities) and investments that typically provide a high rate of return. It’s important to keep saving for retirement even if you don’t have a 401(k).

Does your pension increase with inflation?

Some pensions have a cost of living adjustment on their monthly payments, so they increase over time. However, this is not the case for all pensions. When inflation increases this can affect your benefits.

Photo credit: iStock/RgStudio

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Tax Information: This article provides general background information only and is not intended to serve as legal or tax advice or as a substitute for legal counsel. You should consult your own attorney and/or tax advisor if you have a question requiring legal or tax advice.

Financial Tips & Strategies: The tips provided on this website are of a general nature and do not take into account your specific objectives, financial situation, and needs. You should always consider their appropriateness given your own circumstances.

Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.

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