What is inflation? In economic terms, the definition of inflation (via dictionary.com) is “ “. Basically, inflation makes goods and services more expensive, while reducing the value of your money. While you may not consider inflationary risks due to still being in your prime working years, or simply feeling that it hasn’t been high recently so it can’t matter, the reality is that you need to be planning for the impact of inflation.
When you are working, your wages tend to rise as the cost of goods and services increase. This is where the phrase “keeping up with inflation” comes from in regards to general wage increases. However, when you transition to a fixed income in retirement, inflation can rob your future. Take this example: Say you deposit $100,000 into a savings account that has a 1% interest rate. Because it’s a safe haven account (ie. not a stock or bond or any investment that carries risk), in 10 years you will have $110,462.21 (assuming an annual fixed 1% that compounds). This seems great on the surface, but you need to dig deeper and account for inflation. If you had $100,000 of expenses in April of 2007, you would need $118,307 in today’s dollars. So while your $100,000 savings account didn’t lose in terms of a rate of return, you actually lost $7,844.79 in purchasing power. With the notion that inflation has been lagging for several years now, imagine what will happen as inflation continues to normalize. This is why inflation is sometimes referred to as the “invisible tax”.
With the above in mind, now you can see the impact of inflation not only on someone with a fixed income, but also someone who is still working as you’ll likely need multiples more than you current wages just to maintain the exact same lifestyle you have today. While certificates of deposit (CDs) and savings accounts are considered low risk vehicles, they may actually do more harm than good as your purchasing power could be greatly impacted due to inflationary pressures. While Social Security payments and some pension plans adjust for inflation, if you’re utilizing retirement accounts now or in the future to supplement your income, you will require more money in the future. One final thing to consider, and it’s a separate topic to be addressed, and that is withdrawal rate of these accounts. Maybe you are currently employing a 4%-5% withdrawal rate from your retirement portfolio, but what happens when inflationary pressures are accounted for? That 4%-5% withdrawal rate suddenly might not be enough.
Adam M. Sutton is the founder and president of Cornerstone Financial Partners. Adam is a financial planning professional, specializing in retirement income planning and wealth optimization strategies. He is a Series 66 licensed Investment Advisor Representative (IAR), as well as life, accident & health insurance licensed and is certified to address long-term care. Cornerstone Financial Partners is a privately held, independent financial planning firm.
Full Disclosure: This information does not constitute investment advice. This article is published and provided for informational purposes only. None of the information contained in the article constitutes a recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. To the extent any of the information contained in this article may be deemed to be investment advice, such information is impersonal and not tailored to the investment needs of any specific person. Cornerstone Financial Partners does not provide legal or tax advice, and the contents of this message are not intended to constitute such advice. Please seek an appropriately licensed individual for legal or tax advice in relation to your individual situation.