Inflation Erodes Retirement Savings

Inflation does not literally reduce the number of dollars you possess, but it does reduce your purchasing power.

How inflation is measured

Inflation and deflation describe whether prices of goods are generally rising or falling compared to their cost in the past. If there is 5% inflation from one year to the next, a person would need to spend 5% more this year to purchase the same goods as last year. For example, if an item costs $1 today, after a year of 5% inflation it would cost $1.05. After ten years of 5% inflation that $1 item would cost $1.63. Inflation thus decreases your purchasing power, since a dollar will not buy as much in ten years as it does today. ¹

One commonly used indicator of inflation and deflation is the Consumer Price Index (CPI), calculated monthly by the U.S. Bureau of Labor Statistics. The CPI is measured by sampling prices in a set of urban areas for a representative group of basic household goods and services, including food, clothing, utilities, housing, transportation, and sales taxes. Using statistical weighting, these sampled prices are converted to a single number (an index), which can be compared to a number calculated in the same way for the same group of goods and services each month. The percentage change from one month to the next is generally viewed as a way to quantify inflation or deflation, though some economists and policymakers prefer measures other than the CPI. ²

During the 20-year period from October 2001 through September 2021, the 12-month change in CPI was only negative for 11 of the 240 months, or fewer than 5%. The average 12-month change during that period was a growth of 2%. So annual inflation has hovered around 2% for the past couple of decades. ³

However, a look further back into time reveals the percentage change in CPI spiking during several historical periods, some of them extending for years (see chart). ⁴

What inflation means for your retirement budget

It’s safe to assume inflation will continue into the foreseeable future. What this means in terms of retirement planning is that you’ll need to budget for your annual spending increasing every year just to maintain your lifestyle. Assuming your budget is $50,000 in 2021, then you can expect that same $50,000 will be able to purchase fewer goods and services in 2022, and fewer still in 2031. In fact, if inflation holds steady at an average of 2% per year, you’d need $60,950 to have the same purchasing power in 2031.

Put another way, in the year 2020 you’d need $1.50 in order to buy what $1 would have bought you in the year 2000.⁵ So if inflation remains at an annual average of 2% for the next 20 years, then 20 years from now you’d need $1.50 in order to buy what $1 can get you today.

You can use the Impact Of Inflation calculator on this page to see how inflation could affect the income you’ll need during retirement.

Even when inflation is low, your costs during retirement may continue to rise.

It’s important to remember that the CPI is based on prices in urban areas and is weighted to reflect a broad segment of the population, and so it may not accurately reflect the types of expenses you’ll have during retirement. Retirees aren’t typical spenders; their budget priorities can be very different from those of other groups -- young families, for instance, or workers in their peak earning years.

One class of expenses that is a priority for retirees and that is likely to take on increasing importance in a typical person’s budget as they grow older is healthcare costs. Healthcare costs, unfortunately, have been increasing at a faster pace than inflation. This will disproportionately affect seniors, who spent 3 times more per person for healthcare than working-age adults did in 2019. ⁶

An average healthy couple aged 65 with standard life expectancy will likely see their total healthcare expenses range between $156,208 and $1,022,997 over the course of their remaining lifetimes, depending on where they live and other factors.⁷ One in three retirees report that they are experiencing higher-than-expected healthcare costs during their retirement.⁸

Budget for your future peace of mind.

It’s hard to know the future, but planning ahead can put you in a better position to enjoy your retirement. Run the numbers to estimate your spending needs during retirement, including realistic estimates for healthcare costs and an assumption for annual inflation. This will give you a buffer against rising costs and decreased purchasing power, helping your dollars to carry you further.

Citations.

1 - investopedia.com/terms/i/inflation.asp

2 - bls.gov/cpi/questions-and-answers.htm

3 - Based on 12-month percentage change, not seasonally adjusted, monthly values for Oct 2001 through Sept 2021. bls.gov/opub/ted/2021/consumer-prices-increase-6-2-percent-for-the-year-ended-october-2021.htm

4 - fred.stlouisfed.org/series/CPIAUCSL

5 - measuringworth.com/calculators/uscompare/result.php?year_source=2000&amount=1&year_result=2020

6 - cms.gov/Research-Statistics-Data-and-Systems/Statistics-Trends-and-Reports/NationalHealthExpendData/NHE-Fact-Sheet

7 - hvsfinancial.com/wp-content/uploads/2020/12/2021-Retirement-Healthcare-Costs-Data-Report.pdf

8 - ebri.org/docs/default-source/rcs/2021-rcs/2021-rcs-summary-report.pdf

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