Inflation has been the hot news topic lately. The core inflation rate, as measured by the Consumer Price Index (CPI), rose all the way to 5.4% in June, up from 2.6% just three months earlier. This represented the biggest rise in inflation since 2008.
Different economists have offered different explanations for this rapid spike, including the reopening of the economy in recent months after the pandemic lockdowns and the stimulus efforts of the federal government in response to the pandemic recession. The Chairman of the Federal Reserve, Jerome Powell, says the spikes are a temporary phenomenon caused by the pandemic shutdowns and subsequent reopenings and that inflation will fall back to normal levels soon.
What Exactly is Inflation?
Simply put, inflation is what occurs when prices of goods and services rise over time, as they inevitably do for most things. Inflation reduces the purchasing power of money, since it takes more money to buy something when the price is higher than when it is lower.
Over the past decade, inflation has remained relatively tame, averaging around 2% annually, which puts the recent spike in perspective. But even at 5.4% the current inflation rate is still a long way from where it was in 1980 when it hit almost 15%.
If the prices of most things rise over time — with personal technology being a notable exception — then what’s the big deal? The main concern right now is how fast the inflation rate has risen in such a short period of time — more than doubling in just three months after such a prolonged period of moderate inflation.
Impact on Your Retirement Savings
Given the fact that inflation erodes the purchasing power of your money over time, it’s important to consider how inflation could affect your retirement savings and your financial security during your golden years.
An example helps illustrate the impact of inflation on a retirement portfolio. Let’s consider a retirement portfolio that was worth $100,000 in 2010. If the portfolio earned a 6% annual return, it would be worth $179,084 10 years later in 2020 (assuming no additional contributions). But now let’s factor an annual inflation rate of 2% into the numbers.
This would shave more than $57,000 in purchasing power off the portfolio, reducing its real value from a purchasing power perspective to just $121,899. This example is based on a 2% inflation rate — the impact would be much more drastic if the inflation rate were 5% or higher.
Make Inflation Assumptions
For these reasons, it’s important to consider inflation when making assumptions about your retirement finances. Otherwise, you might not have as much money when you retire as you think you do, at least from a purchasing power perspective.
To do this, choose an assumed annual inflation rate and factor it into to your projected investment returns. While inflation over the past decade has averaged around 2%, the average inflation rate over the past 40 years has been closer to 4% so this might be a safer number, especially considering the recent inflation spike. Also, healthcare and college expenses tend to rise faster than inflation so you might want to assume a higher rate for these.
Finally, remember than the CPI is based on a weighted average of the prices of a representative basket of consumer goods and services like food, beverages, housing, apparel and transportation (including vehicles and gasoline). So the rate of inflation you and your family actually experience could be higher or lower than the government’s official inflation measurement.
For example, apartment rental rates and new automobile and gasoline prices have been rising especially fast this year. If you’re a renter who drives a lot and plan to buy a new car, you might experience higher inflation than a homeowner who doesn’t drive much and plans to keep his late-model car for awhile.
Don’t Discount the Invisible Thief
Inflation is sometimes called “the invisible thief” because it robs your money of its purchasing power, but it’s hard to see on a day-to-day basis. However, inflation is very real, even if you can’t actually see it, so it’s important to consider its impact on your finances and retirement.
Please give us a call if you have more questions about how inflation could affect your family’s current finances and your future retirement security.