One of the ways 2009 made history was by having the most sustained episode of deflation since the 1950s. As the year progressed, however, it was clear that inflation was making a comeback. This emerging trend should be a reminder that planning for inflation is critical to your retirement savings plan.
How inflation affects retirement savings
You still see articles wondering if a million dollars will be enough for retirement. Increasingly, though, new generations should regard the premise that a million dollars is adequate for retirement as a quaint notion.
Given the historical average inflation rate of 3.75% a year, by the time a 25-year old today reaches 70 years of age, he would see inflation turn that million dollars into the equivalent of $190, 781 in today’s dollars. All of a sudden, that doesn’t sound like such a lavish retirement nest egg, does it? Clearly, any retirement savings target has to factor in the effects of inflation over time.
Factoring inflation into a retirement savings plan
Here are some tips for factoring inflation into your retirement savings plan:
- At an average annual rate of 3.75%, inflation will double approximately every 19 years. Use this as a rule of thumb to figure out how many times your cost of living will double by the time you need the money.
- Don’t use your retirement date as the endpoint for your retirement planning. Remember, you could easily live another 20 years or more in retirement — time enough for your cost of living to double yet again.
- Inflation may vary greatly from year to year, but keep that 3.75% average in the back of your mind before locking in any certificates of deposit (CDs) or any other long-term investments. Also be sure to consider the impact of taxes. If you’re looking for a “safe” investment, it’s currently better to keep your bank deposits short and flexible — e.g., in a high-interest savings account or money market account — until bank rates recover.
- In the long run, you’ll need to consider investing more aggressively to protect your nest egg against the devastating effects of inflation. Without the higher returns offered by stocks and bonds, it will be virtually impossible to outpace inflation.
Because of the compounding effect of inflation over time, failing to account for inflation in your retirement savings plan can be as devastating as losing more than half of your money. However, if you get an early start and make sensible investments, you can get the power of compound interest rates working for you rather than against you.
As a financial planner, I use a 3 bucket strategy for my retirees where a portion (safe bucket) is for money markets&CDs and is used for 2-3 yrs of expenses. Middle bucket for income and fairly safe growth (T-Bonds, REITs, Tax-deferred Annuities), and the very important 3rd bucket for growth to counter the effects of inflation (mostly equities). Yes, most retirees cannot afford to retire on fixed income only and need growth in their portfolios. This will likely be even more important in the future when we will have to pay down our Government debt and face higher inflation rates.
Why do I have to go and read posts like this that scare me into wanting to work harder at preparing for retirement?! 🙂 Thanks for the good info!
Thanks for the reminder that saving more as soon as possible is the right retirement plan. As for now, I continue to chop at the debt mountain…putting some toward retirement as well.
BG, IMHO I don’t think short term cds have any inflation protection. Read up on how the CPI-W (consumer price index for workers) is determined and go to the website shadowstats to see what real inflation is. The Gvt determines what inflation is and makes it low so that they won’t have to pay more to the Social Security recepients. And if it looks like the calculations are going to result in a higher CPI, they just change the formula that they determine inflation at. Jim Jubak had a great article a little over a year ago on the CPI, titled “Fake inflation numbers masked crisis” Google it or look it up on MSN Money if the below link won’t get you there. Basicly if you don’t have a pension (DB type) that is adjusted for inflation you are up a creek without a paddle. Like most of the U.S. workforce.
http://articles.moneycentral.msn.com/Investing/JubaksJournal/fake-inflation-numbers-masked-crisis.aspx
#2) I agree — would like to hear more about other ways to protect against inflation (like TIPS). I really don’t like the stocks/bonds alternatives, because there is no guarantee that even they will have a real-return after accounting for inflation.
The problem with TIPS is that they can go down! such as happened last year in our deflationary environment. Another problem with TIPS is that the fox is guarding the henhouse — meaning the Government backs the TIPS, and the Government also determines the inflation rate numbers behind them (no free market).
My question: are short-term CDs (1 month, 3 month) the equivalent to real-world inflation protection? Not looking to earn money, just preserve value. Thanks.
No mention of TIPS?? That’s going to be a big component of our strategy when the time comes.
Wow, &1 million into a little less than $200,000. That is quite significant. Guess it’s its time to start saving more and much earlier.