By Dave Carpenter
Inflation is the long-term threat stalking every portfolio.
The effect may not be very noticeable in the short run. But by the time you’re deep into retirement, inflation can deal a devastating blow to your savings.
Inflation’s impact is like that of high blood pressure — that’s what Francis Fennie of LPL Financial in Redwood City, Calif., tells his clients. “You may not feel it, but if you don’t do anything to guard against it, it’s massively damaging to your financial health over the long run.”
Years of historically low inflation may have lulled consumers into underestimating the consequences.
But higher rates have finally arrived. Consumer prices have risen 3.2 percent in the past 12 months, the highest level in two and a half years. That brings inflation back to near its historical annual average of about 3 percent.
Many financial planners find it hard to impress upon their clients just how serious a risk inflation can be.
Consider the case of a 65-year-old couple with retirement savings of around $600,000.
Financial models show that they should be able to withstand annual inflation of 3 percent throughout their retirement, assuming they’re collecting Social Security and able to earn an average annual return of 6 percent on their savings. But if inflation creeps up by just one percent, it’s likely they would run out of money before both reach full life expectancy.
Even modest inflation is causing Marlis Risberg, a retired office worker from Forest Lake, Minn., to make some changes. The 70-year-old, who is divorced, started taking Social Security four years ago and finds that the $1,000 checks don’t go nearly as far as they used to. She also has a small pension and some certificates of deposit, but it’s all barely enough for basic needs.
“Gas, groceries, medical supplies — everything’s going up,” she said. “You name me one thing that isn’t, aside from the rates on CDs.”
The impact of inflation on retirees tends to be higher than that for others, too, especially in later years of retirement. A large chunk of their expenses tends to be from health care, and those costs are rising faster than overall inflation.
Risberg hears neighbors in her retirement community talk every day about how their income doesn’t cover what they thought it would. Some are buying fewer groceries so they can afford their medications. Others are taking out reverse mortgages.
They’re holding down spending, either out of necessity or in an effort to ensure they’ll still have something left to pass along to children and grandchildren.
So what can be done to offset inflation besides spend less?
For starters, you should acknowledge that inflation needs to be factored into retirement planning.
About 45 percent of retirees fail to account for the effects of inflation, according to a recent study by the Society of Actuaries. And only 5 percent of pre-retirees age 45 and older have a financial plan that extends to or beyond their life expectancy — a long time span that gives inflation more time to erode a portfolio.
Individuals need to take both inflation and longevity into consideration and plan for multiple scenarios.
Here are some moves that can help compensate for future inflation:
1. Invest for growth. You need to make sure your assets continue to grow and generate interest income so your purchasing power stays intact.
Today’s retirements can easily last two or three decades, adding to the financial challenge.
“If you’re planning to manage your portfolio in retirement the way your grandfather did, you’d better wake up,” said Christine Fahlund, a senior financial planner for investment firm T. Rowe Price. “Those retirements were maybe 10 or 15 years long. And they had pensions.”
A $100,000 cash nest egg will be worth just $55,400 after 20 years with annual inflation of 3 percent, as calculated by T. Rowe Price. After 25 years, or age 90 for someone who starts with that amount at 65, it’s down to $41,200. Both scenarios assume a 6 percent annual return on investments.
That makes leaving portfolios mostly in cash, CDs or other conservative investments with very low returns — a popular retirement strategy in years past — a very risky gambit.
Better to have 40 percent to 60 percent in stock at retirement age; you can lower the percentage slightly as you get into your 70s and 80s. A balanced or blended mutual fund that also includes a large percentage of bonds will lessen the risk if you’re uncomfortable about being in stocks.
2. Delay taking Social Security.
Inflation protection is built into Social Security; benefit amounts are revised annually to account for cost-of-living increases. But there were no such adjustments the last two years even while food costs climbed. And taking steps to ensure that your monthly check is as large as possible will help in your battle against inflation.
If you file for Social Security benefits as soon as you’re eligible at age 62, your payments are reduced by about 30 percent from what they would be at full retirement age — 66 to 67 depending on year of birth. After full retirement age, the monthly check increases by 8 percent for each additional year you delay up to age 70.
3. Buy an inflation-indexed annuity.
Annuities — investment products in which you generally pay an insurance company a sum of money and get back a stream of payments for life — scare off many retirees and pre-retirees. They have a reputation for being complex and loaded with fees. But more financial advisers are touting them as a way to receive the guaranteed lifetime income that pensions once provided. You need to analyze the terms carefully and choose a financially healthy insurance company that’s poised to be around for decades.
The initial annual payout rate for an inflation-indexed annuity should be about 5 percent of the purchase price if you retire at age 65, said consulting actuary Steve Vernon. It’s likely to be a bit more if you’re a single man, a little less if you’re a single woman or part of a married couple. Consumer websites such as AnnuityAdvantage.com and DirectAnnuities.com provide rundowns of the various types of annuities and available rates.
4. If your pension does not adjust for inflation, create a side account.
The purchasing power of your monthly pension payment, if you are fortunate enough to have one, will shrink dramatically over the course of a long retirement. To prepare for that, retirees and pre-retirees alike should set up a separate account that can be tapped periodically for additional income.
It could be a short-term bond fund with less volatility than a stock fund, suggests Fahlund, since it is not being counted on as your primary source of retirement income.
5. Supplement Medicare with other insurance.
Buy Medigap supplemental coverage that fills in benefit gaps in traditional Medicare. And consider buying long-term care insurance in your 50s or 60s to help ensure that significant medical expenses later in retirement don’t wipe out your assets. Even without considering the additional costs that advancing age brings, health care costs for families rose 7 percent in the past year and have doubled in nine years, according to a recent report by actuarial firm Milliman.
Significant inflation is almost certain to continue for both health and long-term care expenses. — AP