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Inflation and Your Retirement: What You Can Do to Prepare

It’s no secret that in the last six months we’ve noticed a significant hit to our budgets by way of inflation. The annual inflation rate for 2021 spiked to 7% in December from the same month a year earlier, the fastest climb we’ve seen in the last 40 years. You didn’t even need to read the headlines to know something was up. Your wallet undoubtedly took repeated hits buying gas, food, clothes, etc. We can point to supply-chain issues, labor shortages, and the COVID recession as directly impacting inflation. But the point is your dollar just doesn’t go as far today as it did a few years ago.

When you’re retired and living on a fixed income, this can be especially nerve-wracking. Unfortunately, inflation is here to stay – whether it’s modest or whether it’s high for a period of time inflation is going to be here. Rather than spending time lamenting what we can’t control, I want to look at how inflation can impact your retirement income and what you can do to mitigate it.

What is inflation?

Let’s take a step back and look at what inflation means. Inflation is a decrease in the purchasing power of money. In the last year alone, inflation was 5.4% based on the consumer price index, which is the measure of how prices change from one year to the next for a market basket of consumer goods and services. So, how does that impact you?

To keep it simple, let’s just use an average of 3% inflation and say you need $60,000 a year to live on in retirement today. In twenty years, you’re going to need approximately $108,000 to buy all of those same things that $60,000 will buy today. Or, alternatively, $60,000 will buy in twenty years what $33,000 will buy today.

How inflation affects specific retirement income streams

Social Security and cost of living adjustment

The first income stream I want to look at is the big one – Social Security. Social Security has a cost-of-living adjustment (COLA) that’s meant to stay in pace with inflation. But it is important to understand that it doesn’t always keep pace. That said, Social Security is going to have a massive jump in 2022 to 5.9%, which is probably the biggest increase they’ve had in several years, if not decades. So Social Security will ratchet up – which is great for your retirement.

Pension and inflation

Next, pensions. We have clients that have pension plans from their employers and with almost all of those pension plans we see a monthly check that never grows. If you get $2,300 a month from your job at whatever company, and they’re gonna pay you and maybe your spouse that for the rest of your lives, generally, that number never goes up. So clearly, no adjustment for inflation with this type of pension, which means this money will cover less as inflation rises.

Municipal pensions for employees like firefighters, teachers, and police officers, on the other hand, do have a cost-of-living adjustment, but I haven’t seen any with a true cost of living adjustment. Almost all of those municipal pensions will adjust at 3% for the first $13,000 simple interest. That equates to $390 a year. So if you’ve got an $80,000 pension, ten years after that pension has been taken, it will have grown by $3,900. Over a twenty-year period, you’ve got an $80,000 pension, that pension will adjust by $7,800. So, again if you need $60,000 today to live on, twenty years from now you’re going to need $108,000, so that cost of living adjustment does not keep pace with actual inflation. 

How you can prepare your retirement for inflation

Assess and analyze your retirement income streams

This is probably one of the most important parts of how to build a retirement planning strategy. You need to make sure you have a strategy, not just have a portfolio of investments where you’re going to withdraw money as you need it. Build an actual strategy that outlines the amount of money you need to cover your expenses. Then look at the expenses and identify which expenses will disappear, which expenses won’t disappear, and (out of the ones that won’t disappear) which expenses will go down and which will go up. Outline your needs first, then start looking at where the sources of income are going to come from to meet those needs.

To prepare your retirement income for inflation, you need to understand it. First, look at the accounts where you have systematic income coming from, like a pension, Social Security, annuities, whatever they might be. Then look at IF and HOW they adjust for inflation to see what sort of purchasing power you’re able to maintain throughout your retired life.

Strategize how you can use your various accounts to meet your needs through the years

Next, take a look at what other avenues you can pull money from. What other avenues you can take distributions to hedge against inflation. In other words, you could, hypothetically, be all set just with your Social Security and your pension. They could cover all your income needs for the time being. So you decide to utilize your other accounts to hedge against inflation. That way you can take extra distributions every year from those accounts down the road in order to make sure that you don’t lose your purchasing power and can maintain your current lifestyle.

Look at the fixed dollar amounts you have coming in every single month to supplement your lifestyle. Then start looking at your other accounts, your other investments, and look at them from the perspective of “all right, if I need this money over the next 10, 20, 30 years. 1. How safe is it? And then 2. is it enough supplement, based on a reasonable inflation rate, to cover all of my expenses.” Remember, not all accounts and income streams are structured the same. Be strategic when and from where you take money from accounts through your retirement years.

Build a strategy that accounts for increasing tax rates

Don’t forget, we all have our old silent partner, too. The IRS is a huge consideration, more so now with the inflationary spiral that we’re talking about. For many people, after their home, their largest asset is their 401, IRA, or 403b and they haven’t paid taxes on them yet. It is critical you don’t overlook that. I think most people agree that taxes will go up and will probably continue to rise in the near future. And taxes erode you’re purchasing power.

At South Shore Retirement Services, we do a lot of counseling and public speaking on tax-efficient strategies so much of our work is trying to help clients do is get ahead of their tax burden. For example, we’ve counseled many clients to take advantage of anything that works in their favor in the tax code now. For example, to take advantage of any opportunity that they might have to take money out of these accounts in the low tax environment today, so the taxes are done. Now they don’t have that future worry of how much is it going to get eroded down the road? You really need to look at the whole picture. There’s a way to mitigate much of this but it takes advanced preparation. So, stay aware and stay ahead of it.

Prepare for the tax bracket you’ll be in

The government spending money (or promising to spend money), affects the entire world economy and market. And taxes reflect that. But there are things that can be done in advance to help mitigate the tax impact. Most people are aware that taxes are going to increase, so one way to prepare is to look at what tax brackets you’re in now and see if you’re going to continue in that tax bracket throughout retirement.

When you’re working, you don’t have an awful lot of control about which tax bracket you’re in. When you transition into retirement, many have a window of opportunity. For example, if you’re 65, you have a seven-year window (before you hit 72), if you prepare strategically you have more control over which tax bracket you’re in. But you have to prepare ahead of time. If you don’t, then you hit 72 years old and you lose control again because your required minimum distributions begin. So now you’re required to start distributing all the funds from pre-tax accounts that haven’t paid any taxes on regardless of whether you need them or not. The difficulty is we don’t know what the tax rates are going to be when you’re required to start distributions so you don’t know what the tax rate will be.

Strategies for how to use pre-tax distributions

If you have wiggle room before you are in the next tax bracket, perhaps consider withdrawing some money from these pre-tax accounts when we’re in a lower tax environment, rather than when taxes increase. Keep in mind, paying the taxes when you can control how much the taxes are, doesn’t mean you have to spend the money. There’s a multitude of things you can do with it. With clients we discuss options like reinvesting the distributions in things like Roth conversions, gifting to the kids, aggressively paying down debt. The point is you have options.

Our objective is to help clients minimize their lifetime tax bill, which I think is equally as important as trying to make sure that they’re making money on their money. When you’re not living check to check anymore, you’re looking at the long game. And the long game affords you more opportunities to make moves that are efficient and prosperous for you.

Stress-test your strategy for inflation

The goal should be to stay ahead of inflation and look at what your game plan is going to be should circumstances change. When we meet with clients one of the most important things we do is put together an income strategy with them and look at their lives, what they’re spending money on, and stress-test it. We simply adjust it, when appropriate, for inflation when things need to be adjusted. This stress-tests their money and situation to see if under bad circumstances, or very extreme circumstances, they still have enough money to cover all of their costs. The stress test can help give them financial confidence.

We always go with realistic assumptions, as well. When you’re in the money and numbers business, it’s simple to manipulate numbers and change projections to make everything look really fantastic. But we want to be realistic. Sometimes when clients sit down with us, the scenario is really kind of boring. Which is my goal. I want it to be boring right off the bat. I want it to be stupidly easy to help achieve what we’re looking at because we obviously want returns to be better but if it isn’t better we want to make sure that you can still sustain your lifestyle.

Rethink how you spend your budget

We often talk about the importance of and the helpful benefit of having a budget even an informal one. When I say budget, I mean look at what you spend your money on. If you can cook costs on some things and without giving up the actual thing, great. For example, I eliminated cable from my family expenses and now we just stream through YouTube TV. It’s exactly the same from our perspective but it is significantly less expensive.

When you start looking at budgets look at what you’re actually spending money on. As I said earlier, inflation is based on this basket of goods the consumer price index. But what if the stuff that’s in your basket of goods isn’t the stuff that you actually use? Look at your basket of goods that you’re going to spend money on and how that’s going to evolve and change over time. Maybe you’ll have a mortgage for the first four years of retirement, so you budget for it since it’s been such a staple expense, but you’re not going to need to three years into retirement! The mortgage is going to be done, so you’ve got a “retirement raise”. You need to know how you’re spending your money (I’d say now more than ever). Because there are ways to cut and ways to save even in an inflationary spiral.

Your retirement is in your control, and you can always ask for help

When it comes down to it, everyone just wants to know that they’re going to be okay when they retire. Nobody wants to run out of money. Nobody wants to stress about money. So I think our responsibility as financial professionals is to help make sure that clients are comfortable, confident, and informed. I want them to know that no matter what happens in the world, we are here to help them with their retirement goals. If you build a strategy that prepares for inflation, you hedge against the downside of the market and you have a sort of safety net set in place, you’re on the right track it can help bring you the confidence we’re all looking for. And as always, don’t hesitate to ask for help.

Inflation and Your Retirement plan

Rowlette and Associates, LLC DBA: South Shore Retirement Services – an affiliated company – is an independent financial services firm offering both insurance and investment services. Investment advisory services are offered only by duly registered individuals through AE Wealth Management, LLC (AEWM). AEWM and Rowlette and Associates, LLC DBA: South Shore Retirement Services not affiliated companies. Investing involves risk, including the potential loss of principal. Any references to protection benefits, safety, security, lifetime income, generally refer to fixed insurance products, never securities or investment products. Insurance and annuity product guarantees are backed by the financial strength and claims-paying ability of the issuing insurance company. Our firm is not affiliated with or endorsed by the U.S. Government or any governmental agency. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. 1235726 – 03/22

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