How many of you remember gas prices at 25 cents a gallon or when a loaf of bread was a dime? Do you understand what caused gas or bread prices to soar to $3.00 or more? Product costs go up when the cost of the raw materials increase and demand outpaces supply. An increase in the cost of goods and services often causes individuals to look for ways to either save on expenses or increase their income. This can lead to higher labor costs when employees’ wages increase. These increases are then passed onto consumers with price increases – and the cycle continues.
We are experiencing this right now. There is a shortage of supplies. Anyone looked at how the cost of a 2×4 has increased in the past year? Are you paying more for groceries than you did a year ago? These shortages in supplies are causing price increases in the final products as manufacturers must pay more for their raw materials. Inflation has increased slightly to this point. There is talk that it could go as high as 4% in the next few years.
Why do you care? Inflation is a significant factor that impacts your ability to maintain your desired standard of living. If inflation causes price increases, do you have enough funds to sustain yourself through retirement? Do you have enough funds to maintain your current lifestyle if prices continue to climb without a corresponding increase in income?
Take, for example, an employee retiring with a pension of $75,000 at age 55. Most pensions do not increase once you start collecting – they are locked into an amount for your lifetime on the day you begin collecting. At age 60, the pension will be $75,000 – and it will still be that $75,000 at age 70, 85, and even age 100.
Meanwhile, in our example, when that employee retired at age 55, his expenses were also $75,000. He was living check to check and not saving any of his income. If we use the historical inflation rate of 3%, by age 60, his expenses would have increased to just under $87,000. More recently, inflation has been hovering around 2% or lower – even 2% says his expenses would have increased to just under $83,000. Take that out another 10 years at 3%, and expenses would now be estimated to be close to $117,000. Using the 2% inflationary rate would put the expenses close to $101,000.
How is that 55-year-old going to account for inflation? At some point, they will start drawing Social Security, and it will fill in the gap. Social Security can help do that for a while, but generally, long-term, it does not keep up with inflation either. Many of those that are collecting Social Security say, yes, I got my cost-of-living increase, but my Medicare premiums also increased. My net benefits only went up a few dollars, not enough to keep up with the higher costs of products and services.
Individuals will either need to change their lifestyle over time to keep up with higher costs or need to have funds set aside they can draw on later in life to generate higher cash flow.
Often individuals in the private industry do not start with a pension. Their retirement dollars in their 401(k) must keep up with inflationary cost increases. If your retirement dollars are in a savings account earning less than 1%, these funds are not increasing to keep up with rising costs. Certainly, you need some funds safe and secure that are going to be used soon. You also need funds growing at a pace that matches the impact of inflation to maintain your current standard of living.
While inflation does not increase at a steady rate, taking an example of a historical rate of inflation of 3% and the Rule of 72, it tells us that the cost of living will double every 24 years. If you are currently age 55, that means by the time you are 79, the cost of living would have doubled because of inflation. If you live to age 100, it will come close to doubling again at a 3% inflation rate.
Taking that pension of $75,000 means after 24 years, you could now buy products and services worth $37,500 in today’s dollars. And – then be worth half again around age 100 – meaning your pension is now equivalent to $18,750. That is a tremendous impact on what your standard of living would be!
This is why we stress that you must be saving for your retirement even if you have a pension. It would be best if you had a pot of money to access as expenses go up. Maybe five years out, you now need to get $100 a month from that account. Another five years later, maybe you need to get another $125 for a total of $225 a month from that account. And – continue over time increasing that monthly amount to keep up with inflation.
Market risk is certainly a consideration as you save for retirement, and even more so when you are in retirement and drawing down funds. Just as important is purchasing power risk. You need to make sure that your overall retirement savings outpace or at least keep up with inflation.
We also often stress delaying the collection of Social Security until age 70 for that exact reason. If you draw Social Security at age 62, you take up to a 30% cut in benefits. This means each time the cost-of-living increase occurs, your increased amount is smaller.
If your full retirement benefit amount is $2,000 a month and you choose to take it at age 62, you would receive $1,400 the first year. Using a 1.5% cost of living increase on $1,400 means a monthly increase of $42. If, instead, you are getting that 1.5% increase on $2,000, your monthly increase would be $60. In the 2nd year, that 1.5% cost-of-living increase would be about $43 on the original $1,400 or $62 on the original $2,000. Continue to factor out that impact over 20, 30, or 40 years, and you would see a potential difference of hundreds of thousands of dollars.
The 2nd significant factor that impacts your retirement dollars is income taxes. You need to make sure your funds are outpacing both inflation and taxes – unless, of course, you have been saving in Roth accounts where there is no future tax impact.
Entering the distribution phase of your retirement life can be scary as you stop adding to your retirement dollars and start withdrawing them. Understanding the impact of inflation and taxes on retirement savings can reduce that fear as you put the plans in place to make sure you outpace those factors. We at Planning with Purpose are here to help make sure that your retirement dollars last and make your plans as solid as we can.