How Inflation Works in Retirement
When I started college, the total cost of a year of school at Bryant University was roughly $32,000 (which did not include books). 11 years later, that same institution costs over $50,000 a year. Inflation is the basic economic concept that prices of goods and services rise over time and therefore the buying power of your dollar today will be less tomorrow. If you think about your first car, how much money did it take to fill the car up? Are you paying the same amount today or more? Inflation is the silent killer in any retirement plan, but inflation works differently in retirement.
Spending Habits
In order to understand how inflation has a different impact in retirement, we have to look at what retirees typically spend their money on. According to a consumer expenditure survey, retirees spend the most on items such as housing expenses excluding mortgage payments (30%), transportation (14%), (Health Care 13%). Retirees spend less on mortgage payments, education and entertainment compared to their younger selves.
What Does This Have to Do with Inflation?
The average inflation rates for the 2000s and the 2010s (so far) has been 2.54% and 1.92% respectively* which equates to an average of 2.23% over the last 17 years. Unfortunately, for retirees two of their largest expenditures in retirement are subject to higher than average inflation rates. Inflation on housing comes in a 2.8% per year and health care has a much higher inflation rate at 4.8%. Therefore, as retirees shift their spending habits towards expenses with higher than average inflation rates (health care and housing), their buying power will be diminished at a faster rate.
What Should Retirees Do?
The common financial wisdom assumes that retirees shouldn’t take risks with their investments. Retirees should invest conservatively (i.e. have a much higher proportion of bonds in their portfolio) so that they can withstand a market correction. However, this may not provide the best outcomes for retirees.
Retirements are commonly lasting over 20 years. Healthcare costs alone will double in 15 years with a 4.8% inflation rate. Retirees need to account for this. Retirees should still make sure their portfolio is more conservative compared to someone younger, but it should be designed to beat inflation as well. In order to earn more than 4.8%, an investor would have to invest in equities which historically returns roughly 7-8% per year.
Source: BLS, 2016 Consumer Expenditure Survey f or households w here at least one member has a bachelor’s degree.
Charitable contributions include gifts to religious, educational and political organizations, and other cash gifts. Spending percentages may not equal 100% due to rounding.
Source: BLS, Consumer Price Index, J.P. Morgan Asset Management. Data represent annual percentage increase from December 1981 through December 2017 with the exception of entertainment and education, which date back to 1993. The inflation rate for the Other category is derived from personal care products and tobacco. Tobacco has experienced 7% inflation since 1986 but each age group only spends 0.4%-0.7% on tobacco (21%-37% of combined personal care products and tobacco), which is a lower proportion
-Inflation Rate Source: https://www.statista.com/statistics/191077/inflation