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Why is it important to factor inflation into retirement planning? - Coastal  Wealth Management

By Ryan Glinn, CFP®, MBA, CLTC®

WHAT IS INFLATION?

According to our dear friends at Merriam-Webster, economic inflation is defined as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” To be a bit more concise, inflation is simply the steady increase in price of goods and services in an economy over time.

Inflation can be caused by a variety of factors, however, it most commonly occurs when demand is greater than supply.  When demand exceeds supply, prices will rise until supply can match demand. Excess demand typically occurs when the economy is in overdrive, which is signified by low unemployment combined with high levels of investment and consumer spending. A tight labor market can stress the ability for companies to increase their outputs enough to meet demand. These forces together can push inflation higher.

Inflation can also occur when the money supply outpaces economic growth, as more dollars chase the same amount of goods. Additionally, supply side or cost-push inflation can persist when production costs increase, driving down supply.

Inflation is measured by the Consumer Price Index (CPI). The CPI is a measure of the average price increases of goods and services in the economy year over year. It includes food, utility and energy prices, among others. This gauge typically focuses on price trends in urban areas, which make up eighty to ninety percent of the population in the U.S.[1] From 2019 to 2020, prices rose 1.4 percent.

IS INFLATION BAD?

Believe it or not, a controlled level of inflation is viewed positively. Consistent price growth over time is healthy for the economy. It shows that the economy is growing. This growth is displayed through continued demand, which in turn leads to increased prices and the hiring of new workers to ramp up supply. This explains why the Federal Reserve has set its inflation target at 2 percent. 

However, high levels of inflation can be detrimental to the economy. Too much demand can lead to price hikes, squeezing the average workers purchasing power when wage growth cannot keep up. Furthermore, if you combine this increased demand with an increase in the money supply, hyperinflation can occur. This is when monthly inflation exceeds fifty percent. Remember Germany’s Weimar Republic in the early 1920’s? Already with high debt levels due to war-time financing, the government decided to print money to pay the salaries of striking workers. In 1923, their inflation rate was 322 percent per month.[2] Venezuela and Zimbabwe are more recent examples of hyperinflation.

On the other hand, you could also see inflationary pressures combined with high unemployment and a weak economy. This is referred to as stagflation. The most common example of this is the United States in the 1970’s. Coming off of expansionary monetary policy that had increased the money supply, the U.S. ran into the OPEC oil embargo. The rise in oil prices did not just hurt people at the pump. It hurt many industries and ultimately sent the U.S. into a recession. This oil price shock is an example of supply-side or cost-push inflation.

HOW DOES INFLATION AFFECT MY LIFE?

Inflation impacts your purchasing power over time. A dollar today does not equal a dollar tomorrow when there’s inflation. A gallon of milk in 1960 cost 49 cents.[3] Gasoline was 31 cents per gallon. This is especially important to consider when saving money and planning for retirement. My grandfather told me his biggest shock during retirement wasn’t the Dot Com bubble bursting or stock market route in 2008, but how impactful inflation had become since he retired in the early 1990’s. From 1990 through 2018 the average inflation rate was 2.36 percent.[4]

Bank accounts often cannot keep up with inflation, which is one reason why many Americans invest in the stock market.  A sound financial plan should account for inflation. Retirement planning software such as E-Money, MoneyGuide Pro and Right Capital all have inflation assumptions around the 3% range. This is roughly the historical average of inflation in the U.S. These software assume that you’ll raise your spending each year by roughly 3% to offset the cost of living increase typically caused by inflation. Similar projections can be forecasted using Microsoft Excel. The point is that inflation should be accounted for in some manner, as it has been a constant throughout our history.

Let us consider a retiree who has a $30,000 per year Social Security benefit. That $30,000 per year benefit with no cost of living adjustment pays out $750,000 over 25 years. Adding an annual 2% cost of living adjustment over that same 25-year period would increase total benefits paid to $960,908.99. That is more than a $210,000 difference – roughly $8,400 per year!

CONSIDERATIONS TO HELP PROTECT YOURSELF AGAINST INFLATION.

Inflation can be hedged in a variety of ways. We just mentioned the stock market. Owning stocks has proven to counter inflation over the long run. Certain types of stocks may weather spikes in inflation better than others. For example, companies that have pricing power in their industry can increase prices to offset inflation’s impact. Food and beverage companies within the consumer staples sector are good examples. Utility companies also provide defense against rising prices. You have to eat and pay your electric bill, right? The commodities sector is another area that traditionally acts as a buffer during inflationary times. Companies that operate in oil and gas, timber or precious metals fit the bill here.

A hot topic of late is the rise of cryptocurrencies, such as Bitcoin. Some investors view these “alternative currencies” as a hedge against the U.S. dollar and inflationary pressures. However, cryptocurrencies are a relatively new phenomenon and extremely volatile.

Bonds are typically not the best inflation hedge. Interest rates tend to rise in inflationary environments. When interest rates rise, bond prices fall. However, Treasury Inflation Protected Securities (TIPS) are a type of treasury bond specifically designed to combat inflation. In fact, their principal is linked directly to the Consumer Price Index.

Finally, real estate can be an effective tool to combat inflation. Rental property rates can be increased to reflect overall price changes in the economy. This can hold true in commercial real estate as well. Having exposure to Real Estate Investment Trusts within a portfolio is a way to participate in real estate without physically owning the properties.

WHERE IS INFLATION AT TODAY?

As mentioned earlier, inflation has remained relatively muted over the last year based on CPI. However, much discussion is underway about whether this may change. Some analysts are suggesting the “pent up demand” due to the stay-at-home nature of the COVID pandemic combined with massive government stimulus will lead to inflationary pressures. Most economists predict demand spikes around the back end of this year and in 2022 as more people are vaccinated.

While inflationary pressure is likely to follow any increase in demand, there are counterpoints to notion we will see inflation that is “out of control.” First of all, there’s still a tremendous amount of slack in the labor markets.  In February, the Congressional Budget Office predicted the number of people employed will not reach pre-pandemic levels until 2024.[5] Additionally, should inflation pick up, the Federal Reserve could tighten monetary policy and raise interest rates. There’s little doubt that significant inflationary pressures would put significant pressure on the Fed to control it. 

Certified Financial Planner Board of Standards, Inc. (CFP Board) owns the CFP® certification mark, the CERTIFIED FINANCIAL PLANNER™ certification mark, and the CFP® certification mark (with plaque design) logo in the United States, which it authorizes use of by individuals who successfully complete CFP Board’s initial and ongoing certification requirements.

The information provided does not constitute an offer or a solicitation of an offer to buy any securities, products or services mentioned.  This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. Consult your financial professional before making any investment decision.  Indices are unmanaged and do not incur fees, one cannot directly invest in an index. Past performance does not guarantee future results. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

The example(s) given are hypothetical and are for illustrative purposes. Actual results may vary from those illustrated

Fee-Based Planning offered through W3 Wealth Advisors, LLC – a State Registered Investment Advisor – Third Party Money Management offered through Valmark Advisers, Inc. a SEC Registered Investment Advisor – Securities offered through Valmark Securities, Inc. Member FINRA, SIPC – 130 Springside Drive, Suite 300 Akron, Ohio 44333-2431 * 1-800-765-5201 – W3 Wealth Management, LLC and W3 Wealth Advisors, LLC are separate entities from Valmark Securities, Inc. and Valmark Advisers, Inc.


[1] https://www.bls.gov/cpi/

[2] https://www.econlib.org/library/Enc/Hyperinflation.html

[3] http://www.1960sflashback.com/1960/economy.asp

[4] https://www.officialdata.org/1990-dollars-in-2018

[5] https://www.washingtonpost.com/us-policy/2021/02/01/cbo-economy-biden/

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