For much of the last decade, inflation has been lower than historical standards. But when you plan for the long term, you have to consider the risk that inflation could eat into the buying power of your savings.
For retirees, the effects of inflation can be particularly pernicious. That’s because retirees can no longer seek out higher wages to offset higher prices. To maintain buying power in retirement, they’ll have to rely on inflation protection from pensions, Social Security, annuities, investments, or other income sources.
Are you protected?
The most common sources of retirement income offer varying levels of inflation protection, and the details can be confusing. A survey from the Financial Literacy Center found that more than 40% of people did not understand how Social Security payments react to inflation—never mind pensions, annuities, or investments.
Here we look at 4 different levels of inflation protection, ranging from guaranteed protection* to fixed (i.e., nominal) payments that offer no protection.
1. Payments linked to an inflation index
What it is: An explicit link between the payments you get and the rate of inflation
Where you get it: Social Security payments are linked to one of the government’s official measures of inflation: specifically, the Consumer Price Index-Urban (CPI-U)Opens in a new window. Some public pensions also offer inflation-linked annual increases in payments. Finally, there are fixed-income annuities that offer payments linked to inflation, but you have to buy that protection as an added feature of a policy, and it comes with a cost. All things being equal, the initial payments you receive will be lower if you elect an option linked to the CPI-U.
What it means for you: If you have purchased or otherwise qualify for income that is linked to inflation, once your payments start, the government, your pension administrator, or your insurance company will look at the relevant inflation benchmark or index, and adjust your payments to help keep pace. The adjustments typically happen each year.
The bad news is, these payments tend to use CPI-U, a measure that looks at the average level of inflation experienced by urban consumers overall, and that may not precisely match the inflation that retirees experience as a group, let alone the inflation that any individual retiree will experience. Health care expenses, for example, have been rising at a much higher pace than the CPI-U in recent years.
Still, for the portion of your expenses covered by payments linked to inflation, the risk that inflation will eat away at your ability to cover expenses is greatly reduced.
2. Fixed-rate cost-of-living adjustment (COLA)
What it is: A set increase in payments, typically 1%–5% annually, designed to offset the rate of inflation
Where you get it: Some fixed-income annuities and pensions offer inflation protection in the form of a fixed-rate COLA once your payments begin. Note that, somewhat confusingly, the Social Security Administration (SSA) refers to the adjustments it provides to Social Security payments as cost-of-living adjustments, but unlike other providers of benefits with COLAs, the SSA’s adjustments are linked directly to an inflation index.
What it means for you: If inflation runs at or below the fixed rate during your retirement, COLAs will insulate your income from inflation. But if the inflation rate outpaces your COLA, you will see your spending power decline over time. A COLA will certainly do a better job of keeping up with rising prices than fixed payments without a COLA (see section 4 below), but if inflation returns to the levels seen in the 1970s and early 1980s, a COLA of 2% (a common default) will not be nearly enough to keep up.
3. Uncertain inflation protection
What it is: When it comes to investments like stocks, bonds, and cash, there are no guarantees—at times the returns on these individual investments have outpaced inflation, and at other times they have fallen behind.
Stocks in particular are often pointed to as an antidote for inflation, and while it is true that historically a well-diversified portfolio of stocks has outpaced inflation over the long run, there have been multiyear periods (such as the first half of the 1970s) in which the overall US stock market lagged inflation. What’s more, different parts of the stock market may fare better or worse relative to inflation. So you shouldn’t depend on stocks to protect you against inflation over the short term, particularly for essential expenses like food, utilities, gas, and health care.
Investments explicitly linked to protection from inflation include Treasury inflation-protected securities (TIPS). These are securities issued by the US Treasury, and their value and interest payments are guaranteed to track inflation as defined by the CPI-U—but only if they are held to maturity. A purchaser of TIPS who sells them before maturity may see price changes that do not match inflation. The same is true of inflation-protected bond funds. They hold TIPS (and often other securities as well), but because these funds may choose to buy and sell TIPS rather than hold them to maturity, they cannot guarantee that they will match or exceed inflation.
Where you get it: The stocks, bonds, mutual funds, and additional investments you hold in your brokerage, IRA, or other account
What it means for you: Your ability to cover expenses that you pay for from your investment portfolio could be at risk. You should consider inflation as one risk when you construct an investment strategy.
4. Fixed payments—no protection
What it is: Payments of a fixed dollar amount that do not change to take inflation into account
Where you get it: Many pensions and most fixed annuities do not offer inflation protection (the exception being those annuities sold with COLAs or explicit inflation protection).
What it means for you: As inflation erodes the value of your income over time, these fixed-income sources will almost certainly cover less and less of your expenses. The one key exception is expenses that you can be sure will not change over time, such as a fixed-rate mortgage.
The bottom line
For retirees, the first step is understanding the effect that inflation can have on expenses, and looking at what forms of inflation protection you do, or should, have in your retirement income plan.
Key takeaways
- Inflation can decrease the buying power of your retirement savings.
- A retirement plan should take the risk of inflation into account.
- Different income sources offer different levels of inflation protection.