Why Your Retirement Plan Will Fail: Part Three

Unfortunately, most articles out in the media today focus on a few financial topics; reducing spending/budgeting, paying down debt, buying a house and investing in low cost index funds. While all these topics are important there is one aspect of financial planning that is rarely discussed; describing what retirement is actually like.

Over the next month or so, we are going to take a deep dive into describing retirement from a financial perspective. We are going to look at what risks can derail a retirement and how to create a plan to mitigate those risks. Click the links for Parts One and Two. Let’s continue with the series and focus on inflation.

Think back to when you were younger. What was your first car? How much did that cost? How much would that car be today? Unless you bought your first car yesterday, odds are that the cost of the car is higher today than it was then. The rising cost of goods and services over time is inflation.

In 2017, the inflation rate was 2.11%*. If you started with $100 on January 1st of 2017 and held that $100 to the end of 2017, that same $100 would have the same buying power as $97.89. Retirements usually last over twenty years which means inflation can erode wealth over time. In twenty years, with the same 2.11% inflation rate, that $100 would be worth $65.86. There are years where inflation has been over 4% (2007- 4.08%) and years where it’s been closer to 1% (2015- 0.73%). Inflation rates can be higher for retirees since items like healthcare have a higher inflation rate.

How Does Inflation Impact Retirement?

Most people will retire with a set amount of money saved in a retirement plan like a 401k and/or have some money in an investment account. As most people have built their wealth over time, one of their biggest fears is losing money to a market correction (which we covered in Part Two). As a result, retirees tend to invest their retirement funds in conservative asset classes such as cash, Certificates of Deposits (CDs) or fixed income. Conservative investments offer more security, but they typically offer a “low” rate of return compared to other riskier investments such as equities.

If a retiree keeps too much money in cash which earns virtually a zero percent rate of return, the retiree is essentially losing buying power each year due to inflation just like in the example above. At a 2.11% inflation rate, a retiree would have to earn 2.11% just to break even for the year.

During retirement, a retiree will need to withdraw funds each year in retirement. At the same time, inflation is eroding buying power. Add those two factors together and the buying power that a retiree thought they had could dwindle very quickly. If inflation is 2% and a retiree is withdrawing 4% of their total assets, that means a retiree now must earn 6% to break even.

How Does a Retiree Combat Inflation?

Retirees need to be able to find a balance in their investment portfolio. Investing a portion of their assets in conservative assets like fixed income and cash is necessary to combat market risk. Retirees need to plan to be retired for a long time and should ensure that enough of their assets are invested in asset classes that historically earn a higher rate of return than inflation such as stocks and equity based mutual funds. There is certainly market risk involved with investing in equities, however there is a certain risk in inflation and often it’s harder to see the effects.

Derek Mazzarella is a financial advisor with The Bulfinch Group located in Needham Massachusetts.

*All inflation rates were from US Statistics Beurea: https://www.statbureau.org/en/united-states/inflation-tablesUnfortunately, most articles out in the media today focus on a few financial topics; reducing spending/budgeting, paying down debt, buying a house and investing in low cost index funds. While all these topics are important there is one aspect of financial planning that is rarely discussed; describing what retirement is actually like.

Over the next month or so, we are going to take a deep dive into describing retirement from a financial perspective. We are going to look at what risks can derail a retirement and how to create a plan to mitigate those risks. Click the links for Parts One and Two. Let’s continue with the series and focus on inflation.

Think back to when you were younger. What was your first car? How much did that cost? How much would that car be today? Unless you bought your first car yesterday, odds are that the cost of the car is higher today than it was then. The rising cost of goods and services over time is inflation.

In 2017, the inflation rate was 2.11%*. If you started with $100 on January 1st of 2017 and held that $100 to the end of 2017, that same $100 would have the same buying power as $97.89. Retirements usually last over twenty years which means inflation can erode wealth over time. In twenty years, with the same 2.11% inflation rate, that $100 would be worth $65.86. There are years where inflation has been over 4% (2007- 4.08%) and years where it’s been closer to 1% (2015- 0.73%). Inflation rates can be higher for retirees since items like healthcare have a higher inflation rate.

How Does Inflation Impact Retirement?

Most people will retire with a set amount of money saved in a retirement plan like a 401k and/or have some money in an investment account. As most people have built their wealth over time, one of their biggest fears is losing money to a market correction (which we covered in Part Two). As a result, retirees tend to invest their retirement funds in conservative asset classes such as cash, Certificates of Deposits (CDs) or fixed income. Conservative investments offer more security, but they typically offer a “low” rate of return compared to other riskier investments such as equities.

If a retiree keeps too much money in cash which earns virtually a zero percent rate of return, the retiree is essentially losing buying power each year due to inflation just like in the example above. At a 2.11% inflation rate, a retiree would have to earn 2.11% just to break even for the year.

During retirement, a retiree will need to withdraw funds each year in retirement. At the same time, inflation is eroding buying power. Add those two factors together and the buying power that a retiree thought they had could dwindle very quickly. If inflation is 2% and a retiree is withdrawing 4% of their total assets, that means a retiree now must earn 6% to break even.

How Does a Retiree Combat Inflation?

Retirees need to be able to find a balance in their investment portfolio. Investing a portion of their assets in conservative assets like fixed income and cash is necessary to combat market risk. Retirees need to plan to be retired for a long time and should ensure that enough of their assets are invested in asset classes that historically earn a higher rate of return than inflation such as stocks and equity based mutual funds. There is certainly market risk involved with investing in equities, however there is a certain risk in inflation and often it’s harder to see the effects.

*All inflation rates were from US Statistics Beurea: https://www.statbureau.org/en/united-states/inflation-tables