After decades of hard work, you deserve to relax a little. When you retire, you can spend your time doing whatever you like, from playing golf to joining a book club. To fully enjoy your retirement years, however, you need to save enough money to cover your bills and sustain your desired lifestyle. Unfortunately, inflation can take a big bite out of your savings. Protect yourself by learning more about the effects of inflation on retirement.
What Is Inflation?
Inflation refers to the general increase of prices in an economy. You often hear the term inflation as it relates to increased grocery, energy and entertainment costs. For example, it’s common for news organizations to report on increasing food costs or rising electricity rates. Inflation reduces your purchasing power, forcing you to budget your money more carefully.
Here’s an example. If you have $10, you can buy a dozen eggs for $2, a loaf of bread for $3, a box of pasta for $2 and a small jar of peanut butter for $3. If inflation causes the price of each item to increase by 2%, you can no longer buy all four items for $10. You’ll have to put one of them back or find a cheaper alternative.
Although inflation increases the cost of goods and services, the Federal Reserve doesn’t aim for a rate of 0%. Instead, it has a target of 2%, which is ideal for achieving the Fed’s goals of price stability and maximum employment.
Effects of Inflation on Retirement
Inflation affects the value of your money, so it can also affect your retirement plans. You should know about these two effects of inflation on retirement.
1. Reduced Value of Retirement Savings
Inflation reduces the overall value of your retirement savings by limiting your purchasing power. If the cost of groceries, gasoline, utilities, medical care and other necessities continues to increase, your retirement savings just won’t stretch as far as you’d like. According to the inflation calculator on the Bureau of Labor Statistics website, $1,000 today has the same buying power as $605.45 in October 2004. In other words, what cost you $605.45 in 2004 would cost you nearly double that now.
2. Less Income During Your Retirement Years
Inflation can also reduce the amount of income you receive during retirement. For example, if you have a pension, your benefits will be based on the amount of money you earn during your last few years of employment. If inflation skyrockets just before you retire, your benefit amounts may not be as high as you expected, as they’re calculated without taking inflation into account.
When inflation is high, you also have to reduce the amount of money you withdraw from your retirement accounts each year. For a long time, investment advisors used the 4% rule when helping their clients plan for retirement. If you withdrew 4% from your accounts, you wouldn’t have to worry about running out of money. In times of high inflation, however, you may have to withdraw even less to avoid depleting your retirement accounts earlier than expected.
How to Reduce Inflation-Related Stress During Retirement
You can’t prevent inflation from occurring, but you can take several steps to prevent it from harming your finances during retirement.
1. Pay Off Your Mortgage
Housing eats up a significant portion of most people’s income, leaving very little left over for other expenses. For example, if you net $4,000 per month and have a $1,500 mortgage payment, housing accounts for 37.5% of your net income. Additionally, income usually decreases during retirement, leaving even less for medical care, groceries and other necessities.
Paying off your mortgage eliminates that monthly payment, maximizing the amount of income you have available for other things. Just think about how much better life would be if you had an extra $1,500 per month.
2. Downsize Your Home
If you rent or don’t have the means to pay off your mortgage early, focus on downsizing instead. For example, if you currently live in a four-bedroom home, consider buying something smaller with just two bedrooms. Your mortgage payment is likely to be lower, and you’ll also spend less on heating and cooling. If you rent, look for a smaller apartment or a more affordable complex.
3. Diversify Your Income Streams
Diversification helps limit the risk associated with investing, but it can also help you weather the effects of inflation on retirement savings. If you have just one type of income, it’s difficult to manage rising costs. Diversifying means creating multiple income streams to ensure you have enough to sustain your household during retirement.
For example, if you have a full-time job, starting a side business can help you earn more money. It also gives you an opportunity to make money doing something you enjoy. Another option is to sign up for a side hustle like Uber or Lyft. Put your extra income in an investment account and allow it to grow. You may not make millions, but you can use the extra funds to give yourself a bit of a financial cushion.
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