Inflation occurs when the costs of goods and services experience a sustained increase. Keep in mind that most things go up in price over time, whether there’s an increase in demand or a currency’s value. Simply put, an item you paid for 10 years ago is going to cost you more today due to inflation.
As the US government issues more bonds and prints more money, inflation happens. As a result, businesses begin to raise the cost of their products or services. However, this can also occur if too much money chases only a small number of goods and services; this is called supply and demand. As demand goes up and supply doesn’t, prices will rise.
However, it’s also possible to see an increase in prices anytime a currency loses strength. In particular, you’d notice this with the gas and oil industry.
Take barrels of oil, for example. The US dollar dominates in this business.
So, to buy and sell this product worldwide, every country must first convert its currency into US dollars.
If the dollar loses strength compared to other currencies, whether the result of high debt, a weak economy, or high unemployment rates, it takes more dollars to purchase both currencies and goods and services.
When it comes to devising a retirement plan, inflation creates some unique challenges. For one thing, making adjustments to correlate with inflation is difficult to do.
For instance, if you create a plan that accounts for three percent inflation, you could quickly run out of enough money to live on if it raises any higher than that.
This is why planning for inflation fluctuations is so critical.
Reduced Purchasing Power
Considering that inflation causes the value of a currency to diminish, that currency loses purchasing power. Say the current inflation rate is three percent.
You would need to pay $1.03 next year for something you can buy today for $1.00. Okay, that doesn’t sound too bad, right?
Well, when you look at retirement plans that stretch out anywhere from 10 to 20 years, sometimes longer, it becomes a big deal.
But you do need to remember that things like healthcare, energy costs, and even food aren’t included in the three percent inflation rate.
One of the key goals when developing a retirement plan is to make sure your investments grow enough to offset inflation.
Some people should consider having growth stocks in their portfolios to ensure that money coming in from monthly investments has the same buying power as the previous year.
What Does Inflation Look Like?
To better understand the effects of inflation, here are a couple of examples:
Impact On Retirement
The damage inflation does compounds over time. Let’s look at an example using a retirement planning package called WealthTrace.
I ran a retirement plan where a retired couple is earning 5% per year on their investments and inflation is 2%. In 20 years they have $1 million saved.
But if inflation rises to 3% over this time period, their portfolio value drops to about $700,000.
Why? Because their expenses went up by a compounded 22% over these 20 years.
Inflation also increases most people’s taxes and they might not even realize it.
This is due to the “phantom inflation tax” on capital gains where inflation can generate taxes that otherwise would not have been there.
What About Deflation?
Deflation might sound good, but in reality, this too has some damaging effects. In this case, people hold onto their money as opposed to spending it.
This is when the Federal Reserve will lower interest rates to entice consumers to borrow and spend.
Over time, deflation leads to extremely low demands for products and services.
When that happens, prices drop even lower. For purchasing, this is great, but for anyone with debt, it’s disastrous.
As part of your retirement plan, be sure to pay off all your debt as fast as you can.
This includes things like your mortgage, car loan, credit cards, and so on.
Remember, the dollars spent to pay a debt in deflation are worth more. So, take advantage of this.
Depending on the year and situation, inflation is either stable or high. With massive budget deficits at both state and federal levels, this is a serious problem for America.
Although the US government sells bonds to foreign countries to help finance operations, the US still has enormous outstanding debt.
Should a Retiree Consider Buying Gold?
Touted as the “world’s currency,” gold always maintains pretty much the same value regardless of the country.
In other words, its value is the same in the US as it is in Europe and China.
Especially during a political crisis or economic downturn, people buy gold. The problem is that no one will carry gold bullion around to pay for products or services.
While the value of gold continues to remain relatively stable, it too experiences rises and falls. Ultimately, gold is a good hedge against inflation.
However, that doesn’t mean there aren’t any risks. Many investors have overvalued its price.
Not only that, but countries tend to stock up on gold so that they have something of value during periods of unrest.
Unfortunately, there’s no way to determine its exact value at any given time.
When planning for your retirement, make sure you factor in inflation changes. Even if you feel confident, it’s always a good idea to sit down with a reputable financial advisor to help you outline your plans for retirement.
Alexis Smart says
Over the course of your working and retired lives, inflation will continue to erode the purchasing power of your retirement savings. As you save, remember that food, transportation and healthcare are also likely to cost significantly more than they do today.
Sattva C says
Inflation eats the gain of accretion of savings. Ideally one needs to ensure growth should be greater than inflation so that it does not deplete the capital investment.
Digital Gold says
Agreed with your points. Having investments that keep pace with inflation while continuing to make contributions (preferably inflation adjusted) is the best case scenario. The greater the difference between your investment returns and inflation, the more you’ll have to live off when you retire.