What is Inflation?
Inflation is the decline of purchasing power of a given currency over time. It’s a quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. The rise in the general level of prices, often expressed as a percentage, means that a unit of currency effectively buys less than it did in prior periods.
What is a Pension?
A pension plan is an employer-sponsored retirement plan that provides income during retirement or upon the termination of a worker’s employment. These can be offered in both the public and private sector, though they are becoming less common in the private sector. Under a pension plan, employees receive a set income during retirement that is related to how long they worked at the company. The income is funded by the employer rather than the employee.
Employees do not have control of investment decisions with a pension plan, and they do not assume the investment risk. Instead, contributions are made by the employer to an investment portfolio that is managed by an investment professional. In some cases, employees may also make contributions, which can be either required or voluntary. The sponsor, in turn, promises to provide a certain monthly income to retired employees for life.
How Does Inflation Affect Retirees?
The primary concern for retirees is how inflation affects their purchasing power. Often, retirees rely on a combination of Social Security Income, their savings, and a pension income, if they have one, to pay their bills during their retirement. This is true even if inflation remains low because retirees are more likely than younger consumers to spend money on things that tend to increase in price, such as healthcare. Take this example: A 1% inflation rate would reduce the value of a $25,000 annual pension benefit to $20,488 after 20 years; a 2% inflation rate would erode its original value by a third, to $16,690, according to the National Association of State Retirement Administrators.
How Much Will Your Money be Worth in 10 or 20 Years?
Even moderate inflation can have a significant effect on a retiree’s savings. The Federal Reserve’s target inflation rate is 2%, but the Fed has said it will allow inflation to rise above that mark for some time. Let’s take a look at how an average annual inflation rate of 3% over the next 20 years would impact your finances. If you had a $60,000 a year pension, in 20 years you would require $108,366.67 to match today’s purchasing power of $60,000. Another way to look at it: At 3% annual inflation, that initial $60,000 would be worth only $33,220.55 in 20 years.
You need to factor inflation into your retirement plan because you can expect that everyday items, travel and other expenses will continue to rise in cost. Inflation affects retirees more so than people who are still working because they are often on a fixed income for the rest of their lives. Inflation erodes the value of savings and will continue to do so after you retire. Considering the near-zero interest rates of savings accounts, retirees who are living off their savings are especially vulnerable to high inflation.
Average Life Expectancy
The term “life expectancy” refers to the number of years a person can expect to live. By definition, life expectancy is based on an estimate of the average age that members of a particular population group will be when they die.
According to the U.S. Census Bureau data in 2019, men in the United States aged 65 can expect to live 18.2 more years on average. Women aged 65 years can expect to live around 20.8 more years on average. Therefore, if the average person retires at age 65 there is a very likely chance that he or she will live at least another 20 years. Often, FDNY members retire in their 50’s thus making inflation even more of a factor compared to an average person retiring at age 65.
What Can You do to Fight Inflation?
While retirees can’t directly affect the inflation rate, there are ways to minimize the shadow it casts over their retirement. Reducing housing costs, for instance, is a step in the right direction. Trading in a larger home for a smaller one, even if the mortgage is paid off, reduces the monthly outflow for property taxes, utilities, homeowners’ insurance, and maintenance.
Consider any fixed-income sources in retirement that will not likely keep pace with inflation. In the process, consider how much interest you are earning from money in a savings account or CD. It’s unlikely that we will see a substantial increase in the interest rates that you can earn from a savings account in the bank, so be prepared to continue earning little interest. It’s important to assess your investment strategy and retirement income plan to see if you’re protected against inflation for the long term.
Next, calculate how much your nest egg is right now. As you do, factor in inflation over the next 10, 20 and 30 years. Consider that while overall inflation rates may fall from what they are now, that might not be true for some of the specific goods and services that could take a large chunk of your income, such as energy, food or health care and long-term care costs.
Consider whether your current investment strategy will need to change once you retire. Foundationally, a solid plan ensures that your purchasing power needs are always met. Some people may need to take on less investment risk once they near and reach retirement.