Inflation is ever-present and something we all have to live with. Yet when talk of retirement planning comes up, inflation barely rates a mention. Maybe it’s because inflation has been low in recent years, so we think that it doesn’t make that much difference. Or perhaps it’s because if we do fully recognize the effects of inflation on retirement planning, future projections look a lot less certain.
Retirement Portfolio Projections Can Dazzle, However . . .
Let’s say that you’re 35 years old, you earn $60,000 per year, and you decide that in order to have a comfortable retirement you’ll have to earn $40,000 per year from your retirement portfolio. Assuming a safe withdrawal rate of 4% per year, you will need a $1 million for retirement portfolio by the time you turn 65.
With 30 years to prepare for retirement, and assuming an 8% average annual rate of return on your portfolio, you find you can get to the $1 million mark by saving just 10% of your annual salary. One million dollars by saving 10% of your pay each year – that’s pretty good!
But not so fast.
What Inflation Can Do to a Retirement Portfolio
When we look at “little bit of inflation” it’s often easy to underestimate or even ignore its consequences. It may not make a difference if you’re planning only a year two out, but if you’re making plans for decades into the future it will be a factor – a major one.
In our example above, we’re looking at retirement 30 years out. What effect will an inflation rate of just 3% have on those plans?
3% inflation over a 30 year period will mean that it will cost $2,427 to buy what $1,000 pays for now. If we apply that conversion to our $1 million retirement portfolio, the portfolio’s purchasing power in 30 years will be a little below $400,000. You probably won’t be able to retire on that much money, at least not the way you hope to.
A 3% rate of inflation isn’t arbitrary either. It’s actually the average rate of inflation over the most recent 30 year period, from 1982 to 2012, according to the Bureau of Labor Statistics Inflation Calculator.
How to Compensate for Inflation in Your Portfolio
If you are basing your retirement projections on straight portfolio performance you’ll need to adjust your strategy in order to compensate for inflation. Depending on your age that may mean that you’ll have to double or even triple the amount of money that you’ll need to have. That will require making larger contributions especially in the early going.
Some Investment Choices Handle Inflation Better than Others
It may also call for shifting some investment choices. You might, for example, put a heavier emphasis on sectors such as emerging markets and technology that tend to outperform the general market over the long-term.
You may also want to add holdings in sectors that benefit from inflation, such as energy and precious metals. These positions may not be very effective in times low-inflation, but they could be the high performers when inflation gets ugly.
When All Else Fails
Another strategy is to look beyond your retirement portfolio. That may mean planning to retain income earning skills such as a job or your own business. This isn’t to say that you’ll never be able to retire, but rather that you won’t be relying entirely on your retirement portfolio in the event that the inflation bite is particularly severe.
Part of the problem with inflation is that it’s impossible to know what it will be in the future. We can base estimates on past performance, but the future could look very different. No matter what, some allowance for inflation has to be built into your retirement portfolio plan.
We also have to remember that retirement planning is an attempt to prepare ourselves financially for a time that has not yet come, and that‘s never better than a guess. There are all kinds of variables, some of which we can never imagine or plan for even if we could.
We need to make our best effort to plan for retirement, but trust in our Heavenly Father who provides for us throughout our lives. Even if we don’t quite get it right, he’ll be there for us.
Some trust in chariots and some in horses, but we trust in the name of the Lord our God. – Psalm 20:7 (NIV)
Are you financially preparing for retirement? How will you account for inflation? Leave a comment and tell us your story!