“Inflation is a reliable problem because it’s intentionally created by government policy. Since the advent of the Federal Reserve, the government has destroyed the purchasing power of the dollar by almost 90 percent… twice!”
Todd Tresidder, How Much Money Do I need to Retire?
1. FACTOR IN THE RELIABLE
Tresidder’s words resonate deeply in today’s economic climate where inflation has surged to alarming levels. From the aisles of grocery stores to the arrival of monthly utility bills, the tangible impact of inflation is unmistakable. Just a month ago, as I reached for my youngest child’s favorite jello, I was taken aback to find its price had skyrocketed by a staggering 50%. Such fluctuations have become all too common, affecting everyday essentials that many of us rely on. Undoubtedly, you’ve noticed similar price hikes in your own experiences with staple purchases.
Inflation’s sharp rise has prompted widespread concern, particularly among those nearing retirement age. As individuals contemplate their financial future, the specter of inflation looms large, threatening to erode the purchasing power of their hard-earned savings.
Consider this: if all goods and services remained steady at 3%, an individual’s budget would hypothetically need to double every 24 years to maintain the same purchasing power. For instance, if you’re currently 55 years old with an annual budget of $100,000, by the age of 79, you would require $200,000 annually to sustain your lifestyle. However, if inflation were to persist at a higher rate, say 4%, the timeframe for this doubling effect would shrink significantly.
I recently shared a practical example with a retiring friend that I believed would resonate with him. Knowing his fondness for a good steak, I posed a question during our meal: “Are you enjoying that steak?” His emphatic “Yes” was expected. I then followed up with a thought-provoking statement: “Given the impact of inflation, let’s ensure you can still afford one in 20 years.”
2. THE TROUBLE WITH PROJECTING INFLATION
Economies often aim to maintain a moderate level of inflation, typically within a target range, as it can serve several beneficial purposes like promoting economic growth, helping reduce debt, encouraging investment, fostering wage growth, and helps signal changes in supply and demand. However, it’s essential to note that while moderate inflation can have these benefits, high or unpredictable inflation rates can be detrimental to an economy. Excessive inflation can lead to reduced consumer purchasing power, uncertainty in financial markets, distortions in resource allocation, and ultimately, economic instability. Therefore, central banks and policymakers typically aim to strike a balance by implementing monetary policies to keep inflation in check while supporting economic growth.
Predicting inflation accurately presents a formidable challenge for economists and policymakers alike. The current rate of inflation in the United States, standing at 3.4% as reported for April 2024 according to the U.S. Bureau of Labor Statistics.1 This figure has changed dramatically throughout this decade, highlighting for all of us the dynamic and evolving nature of inflationary pressures.
Compounding the complexity is the fact that inflation does not affect all goods and services uniformly. For instance in April 2024, water, sewer, and trash collection increased 5.3%, Care of invalids and elderly at home 13.9%, and Motor vehicle insurance 22.6% compared to the same period in 2023, indicating the disparate impact across different sectors of the economy.2 These fluctuations make forecasting inflation trends a daunting task as diverse factors such as supply chain disruptions, geopolitical tensions, and monetary policy decisions interact in unpredictable ways to influence price levels.
3. THE IMPACT OF INFLATION ON RETIREMENT SAVINGS
Inflation can have significant implications for retirement savings, affecting retirees in multiple ways.
Purchasing Power
Firstly, inflation erodes the purchasing power of retirees’ savings over time. As the general price level rises, the same amount of money buys fewer goods and services, diminishing the standard of living for retirees. This erosion of purchasing power can be particularly challenging for retirees who rely on fixed incomes, such as pensions or annuities, as their purchasing power diminishes with each passing year.
Investment Returns
While certain investments, such as stocks and real estate, may provide a hedge against inflation by potentially offering higher returns over the long term, other fixed-income investments like bonds may struggle to keep pace with inflation, leading to diminished real returns. Additionally, retirees may face increased volatility in their investment portfolios as they seek to balance the need for income with the imperative to preserve capital against the erosive effects of inflation.
The Net Effect
The “Net Effect” of inflation on retirement planning encompasses the intertwined impact of both purchasing power and investment returns. Retirees must navigate the delicate balance between preserving the purchasing power of their savings and generating sufficient portfolio growth to sustain their desired standard of living over time. Focusing solely on purchasing power may overlook the importance of investment returns in maintaining the long-term viability of a retirement plan, while solely emphasizing portfolio growth may underestimate the erosive effects of inflation on the real value of savings. Therefore, retirees must carefully assess the net effect of inflation on both aspects simultaneously.
4. FLEXIBILITY AND ADAPTATION
Flexibility and adaptation are paramount for retirees as they navigate the ever-changing landscape of retirement planning. We encourage our clients toward regular updates to their retirement plan, incorporating current inflation rates, portfolio returns, and market conditions. Regular updates allow retirees to view real data and make informed decisions.
By acknowledging the uncertainty inherent in financial markets and economic conditions, we can help retirees proactively adjust their plans to reflect reality rather than relying on static assumptions. Each update presents an opportunity to assess the viability of their retirement strategy, identify potential gaps or shortcomings, and implement necessary adjustments. Whether it involves revising spending habits or exploring adjustments to their investment strategies, retirees can leverage these adjustments to align their financial plans with their evolving needs and circumstances. Embracing flexibility and adaptation empowers retirees to maintain financial resilience and pursue their desired retirement lifestyle.
5. THE 4% RULE
The 4% rule is a widely recognized guideline that helps individuals determine the safe withdrawal rate from their retirement savings each year. This rule provides a structured approach to managing one’s retirement funds, aiming to strike a balance between enjoying retirement and ensuring that the savings last throughout one’s lifetime.
The premise of the 4% rule is relatively straightforward. Here’s a breakdown of how it operates:
Initial Withdrawal: Upon retirement, individuals are advised to withdraw 4% of their portfolio in the first year. This initial withdrawal sets the tone for the subsequent years.
Adjustment for Inflation: The subsequent withdrawals are adjusted for inflation, allowing retirees to maintain their purchasing power as the cost-of-living increases.
Historical Market Returns: The 4% rule is rooted in historical market returns, aiming to provide a sustainable income stream based on past market performance.
30-Year Horizon: This strategy is designed to ensure that retirees’ savings last for a 30-year period, catering to the average length of retirement.
The 4% rule is underpinned by several key considerations and rationales.
Historical Performance: It is based on historical market returns and the performance of investment portfolios over time, providing a degree of predictability based on past trends.
Inflation Protection: The adjustment for inflation seeks to safeguard retirees from the erosive effects of inflation, allowing for a consistent standard of living throughout retirement.
Longevity Planning: By aiming for the savings to last 30 years, the 4% rule encourages individuals to plan for a potentially lengthy retirement period, factoring in uncertainties like increasing life expectancies.
To understand how the 4% rule works, let’s consider a specific example. Imagine a retiree with a retirement portfolio of $1,000,000. According to the 4% rule, in the first year of retirement, the retiree can withdraw $40,000, which is 4% of their initial retirement portfolio balance. This withdrawal amount is considered a safe and sustainable rate, as it takes into account the potential growth of the remaining portfolio.
Now, let’s factor in inflation. If the annual inflation rate is 3%, the following year’s withdrawal would be $41,200. This amount is calculated by adding the previous year’s withdrawal of $40,000 to the inflation adjustment of 3%. By adjusting the withdrawals for inflation each year, the retiree can maintain their purchasing power and ensure that their income keeps up with the rising cost of living.
The main goal of the 4% rule is to provide retirees with a steady income stream while preserving their retirement savings over the long term. By adhering to this guideline, retirees can strike a balance between enjoying their retirement years and ensuring that their savings last throughout their lifetime.
It’s important to note that the 4% rule is not a one-size-fits-all solution. Individual circumstances, such as personal expenses, investment returns, and retirement duration, can vary greatly. Therefore, it’s crucial for retirees to assess their unique financial situation and consult with a financial advisor to determine the most appropriate withdrawal rate for their specific needs.
6. RETIREMENT SAVINGS CONFIDENCE
Retirement planning is a crucial aspect of financial management, and seeking the guidance of a financial advisor can greatly enhance one’s preparedness for retirement. Here’s how a financial advisor can provide specific advice for retirement planning and some of the tools they use:
Tailored Advice
Financial advisors can offer tailored advice based on an individual’s unique financial situation, retirement goals, risk tolerance, and time horizon. They can help clients understand the various retirement investment options available and create a comprehensive plan that aligns with their specific needs and aspirations.
Cash Flow Analysis
Financial advisors use cash flow analysis tools to assess their clients’ current income, expenses, and savings patterns. By understanding these factors, they can help clients optimize their cash flow to maximize savings for retirement while balancing their current financial obligations.
Risk Assessment and Management
Financial advisors employ risk assessment tools to evaluate the level of risk in a client’s investment portfolio. They help clients understand the potential risks associated with different investment options and develop strategies to manage and mitigate these risks to safeguard retirement savings.
Investment Portfolio Optimization
Using investment analysis tools, financial advisors can assess the performance of different investment options and help structure their clients’ portfolios to pursue long-term growth while managing risk. They can suggest diversified investment strategies to enhance the potential for higher returns in preparation for retirement.
Tax Planning
Financial advisors employ tax planning tools to assist clients in reducing their tax liabilities in retirement. By strategically structuring investment accounts and utilizing tax-efficient investment vehicles, they aim to improve clients’ after-tax income during retirement.
Longevity Planning
Financial advisors use longevity planning tools to help clients estimate their life expectancy and prepare for the financial implications of a longer retirement. By considering factors such as healthcare costs, inflation, and potential changes in living arrangements, they can support clients in making their savings more likely to sustain them throughout retirement.
In conclusion, seeking professional advice from a financial advisor can provide invaluable support in crafting a robust retirement plan tailored to individual needs and aspirations. By leveraging various tools and expertise, financial advisors can offer personalized guidance to bolster confidence in one’s retirement savings and enhance overall retirement preparedness.
This proactive approach can empower individuals to make informed financial decisions, ultimately leading to a more secure and fulfilling retirement.
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Footnotes
- See the U.S. Bureau of Labor Statistics: https://www.bls.gov/news.release/cpi.nr0.htm
- See Here’s the Inflation Breakdown for April 2024 — In One Chart by Greg Iacurci, CNBC, May 15, 2024: https://www.cnbc.com/2024/05/15/heres-the-inflation-breakdown-for-april-2024-in-one-chart.html
Disclosures
TruWealth Advisors, LLC is an SEC registered investment adviser located in Louisiana. Registration does not imply a certain level of skill or training. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or financial advice. You should consult your own tax, legal and financial professionals before engaging in any transaction. Past performance does not guarantee future results. Additional information about TruWealth Advisors, including our registration status, fees, and services is available on the SEC’s website at https://adviserinfo.sec.gov/firm/summary/306876.