What is inflation?
You may have heard of the Consumer Price Index — or been surprised at the sudden realization that your groceries cost a lot more today than they did a decade ago. But what is inflation, really, and how does it affect your retirement planning? Here’s what you need to know and how to manage this often-overlooked risk.
Inflation describes the growth rate of prices over time. While many countries in economic turmoil have experienced hyper-inflation (where prices rise extremely quickly in a short period of time) or deflation (where prices fall), most of the time inflation occurs at a slow and relatively steady pace.
Those slow changes to the price level means that, for the most part, you probably aren’t aware of inflation — until the cost of eggs or gasoline suddenly jumps out at you.
You’re not the only one taking notice: the cost of these kinds of typical products form the foundation of inflation rate tracking. The typical measure you’ve probably read about is the Consumer Price Index (CPI), which monitors the cost of a bundle of commonly used goods and services over time.1
The CPI offers a simple measure of how quickly the prices of those goods and services are changing, and it provides important insights into the cost pressures that consumers face in different areas.
The effects of inflation
So how quickly are prices rising?
The long-term average inflation rate in the US is 3.28%. At this rate, the prices consumers face roughly double every 20 years. But more recently, inflation has been even lower, hovering around 1% per year.2
However, even at relatively low rates, inflation will still decrease your buying power over time. The long-term effects can be dramatic — much more so than most people realize.
For example, let’s suppose that your retirement budget comes to $50,000 per year and inflation is 1% per year. Assuming the effects of inflation compound daily, you’d need over $55,000 in ten years to enjoy the same purchasing power. After 20 years, you’d need over $61,000.3
That might not seem like much, but if inflation is just a little bit higher (say, 3.28%) the result is even more noticeable. With a $50,000 retirement budget today and daily compounding, you’d need about $95,000 in 20 years to cover the same costs.
In other words, while the difference between 1% and 3.28% might seem insignificant on surface, it’s anything but. Even a 1% inflation rate will impact your purchasing power over time — and the higher inflation goes, the more dramatic the effect will be. The problem is that we don’t know what the inflation rate will be in the future: whether it’s closer to 1% or 3% (or even something else entirely) is anyone’s guess.
Not all inflation is created equal
There is one other wrinkle in understanding inflation: not all prices rise at the same rate. If you’re a parent, for example, you’ve probably noticed that a college education is far costlier today than it was in your day and age.
Consider this: if Harvard’s tuition hikes had simply tracked inflation since 1971, the school would be charging about $15,000 today.4 By comparison, the actual annual tuition at Harvard exceeds $45,000.
These kinds of inflationary pressures are not confined to education. Another area that retirees and pre-retirees in particular need to pay attention to is healthcare. Medical care service costs rose 3.57% in the past year, and in the past 10 years they’ve risen a total of 40% — far outpacing inflation.5
Even within the larger “medical care” category, inflation rates can vary widely from one service to another. For example, nursing home care costs rose 4% last year, while home health aide services rose only 1%.6
These kinds of variations can make planning difficult and even stressful, as it’s almost impossible to know how costs will change over the coming decades for the services that you may or may not need.
How to cope
Dealing with inflation risk requires striking a balance between the need for asset growth to cover rising prices and the need for security and stability. Higher-return investments may provide returns that exceed inflation, but they often carry higher risks. Investments which track inflation might help, but they might be subject to other risks.
With all the options out there, it can be helpful to speak with an advisor about constructing a portfolio that takes inflation into account while adhering to your personal risk preferences and time horizon.
But you can also think beyond asset allocation. For example, you might consider delaying retirement by working part-time or continuing your career a bit longer. You could look into freeing up space in your budget by downsizing or adjusting your lifestyle once retired. Both of these approaches will give your asset base more opportunity to compound and grow, which can help to mitigate the effects of inflation.
It can be hard to make sacrifices today when you’re not even sure how prices will look in the future. But taking steps to prepare yourself can help to reduce your chances of seeing significant declines in your purchasing power over time. Taking action now can help ensure that you’ll be able to afford the priorities later on down the road.