Inflation and Your Retirement Income Strategy

August 21, 2015

You might not think much about inflation. After all, it’s been quite low for the past several years. Still, you may want to take it into account when you’re planning your retirement income strategy. 

Of course, no one can really predict the future course of inflation. But it’s a pretty safe bet it won’t disappear altogether — and even a mild inflation rate, over time, can strongly erode your purchasing power. Consider this: If you were to purchase an item today for $100, that same item, in 25 years, would cost you $209, assuming an annual inflation rate of 3%. That’s a pretty big difference. 

During your working years, you can hope that your income will at least rise enough to match inflation. But what about when you retire? How can you minimize the impact of inflation on your retirement income?

 One thing you can certainly do is include an inflation assumption in your calculations of how much annual income you’ll need. The number you choose as an inflation factor could possibly be based on recent inflation levels, but you might want to err on the conservative side and use a slightly higher figure. Since you may be retired for two or three decades, you might have to periodically adjust the inflation factor to correspond to the actual inflation rate.

Another important step is maintaining an investment portfolio that can potentially provide returns well above the inflation rate. Historically, stocks have been the only investment category — as opposed to investments such as Treasury bills and long-term government bonds — whose returns have significantly outpaced inflation. So you may want to consider owning an appropriate percentage of stocks and stock-based investments in your portfolio, even during your retirement years.

Now, you might be concerned at the mention of the words “stocks” and “retirement years” in the same sentence. After all, stocks will fluctuate in value, sometimes dramatically, and even though you may be retired for a long time, you won’t want to wait for years to “bounce back” from a bad year in the market. But not all investments move in the same direction at the same time; spreading your dollars among a range of asset classes — large stocks, small and mid-cap stocks, bonds, , certificates of deposit (CDs), foreign investments and so on — may help you reduce the impact of volatility on your portfolio. 

And you don’t even have to rely solely on stocks to help combat inflation. You could also consider Treasury Inflation-Protected Securities, or TIPS. When you purchase a TIPS, your principal increases with inflation and decreases with deflation, as measured by the Consumer Price Index. Your TIPS pay interest twice a year, at a fixed rate; this rate is applied to the adjusted principal, so your interest payments will rise with inflation and fall with deflation. When your TIPS matures, you will receive adjusted principal or original principal, whichever is greater. As is the case with other bonds, though, you could choose to sell your TIPS before it matures.* 

 Work with your financial advisor to help decide what moves are right for you to help protect your retirement income from inflation. It may be a “hidden” threat, but you don’t want to ignore it.  

*Yield to maturity cannot be predetermined, due to uncertain future inflation adjustments. If TIPS are sold prior to maturity, you may receive less than your initial investment amount. If bonds are not held in a tax-advantaged account, investors will be required to pay federal taxes on the accredited value annually, although they will not receive any principal payment until maturity. When the inflation rate is high and the principal value is rising significantly, the taxes paid on TIPS may exceed interest income received. Therefore, TIPS may not be suitable for investors who depend on their investments for living expenses.

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