An often-overlooked factor when it comes to planning a retirement nest egg is the negative effect of inflation. While it may very well be true that $500,000 or $1 million is enough to finance your retirement in today’s dollars, when you factor in inflation, those big numbers can shrink rapidly.
Loss of purchasing power and the compounding effects of inflation are two big drags on the value of your retirement account, but many investors don’t fully understand them. So, what exactly do they mean and what can you do to combat them? Read on to find out.
What Is Loss of Purchasing Power?
Loss of purchasing power refers to the decrease of how much you can buy with a given amount of money. For example, if you have to spend $3 to buy one dozen eggs today but that same dozen costs $4 in the future, you have lost about 33% of your purchasing power. Over time, loss of purchasing power is almost inevitable, as inflation nearly always runs at a positive rate.
Even if inflation temporarily turns negative, such as during a severe recession, it’s almost a given that over time the price of goods and services will rise.
In 1952, for example, the average price of a new car was just $1,700. Seventy years later, in 2022, the average new car now costs over $47,000, according to Consumer Reports. Similar comparisons could be made for the prices of everything from homes to bread. Since your retirement may last 30 years or even longer, you should plan for the purchasing power of your nest egg to diminish over time.
The Compounding Effect of Inflation
Inflation can be devastating to a retirement nest egg not just because it rises over time, but because it also compounds. For example, if inflation holds steady at 4% per year, prices might be expected to double in 25 years, but in reality they will double in closer to 13 years. Over a long retirement, this compounding effect becomes even more pronounced.
At a 4% rate of inflation, prices will just about quadruple in 25 years, meaning a static, uninvested portfolio of $1 million will only have purchasing power of about $250,000 after 25 years. This is an important concept to understand when planning out your retirement savings goal.
Given that inflation is going to attack the purchasing power of your retirement nest egg, it’s important to fight back from an investment perspective. Although bonds can provide you with regular income and aren’t as risky as stocks, equities offer the growth your portfolio will need to help counteract inflation. After you factor in taxes and inflation, bonds often offer negative “real” returns, whereas stocks have a long-term record of net positive returns.
Given the corrosive effects of inflation, it may actually be more risky to your long-term returns to be out of stocks than to be in them.
Social Security Cost-of-Living Adjustments
Another weapon you have in the battle against inflation is the annual cost-of-living adjustment offered by the Social Security Administration. Every year, the SSA adjusts payments upward based on the rate of inflation the prior year. For much of the 2000s, the annual COLAs have been small — or even nonexistent — due to persistently low inflation rates. But in January 2022, Social Security payments were boosted by 5.9%, the highest bump since 1981.
For 2023, some forecasts are estimating a COLA as high as 8%, as inflation rose 8.6% year-over-year as of May 2022. The annual COLA is thus an important tool in helping protect your nest egg against inflation, particularly if the bulk of your retirement income comes from Social Security.
The Bottom Line
Although the math of inflation can seem daunting, there are things you can do to minimize its effects. The first step in understanding exactly how inflation works and the effects it can have. The next is to ensure that your asset allocation can help protect you from rising inflation over the course of your retirement.
Maximizing your Social Security benefit and taking advantage of your annual cost-of-living adjustments is another essential step in protecting your retirement from inflation.
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This article originally appeared on GOBankingRates.com: How Big of a Threat Does Inflation Pose to Your Retirement?