What is inflation?
When you see the term inflation in the media, it refers to a change in the Consumer Price Index (CPI), which tracks the cost of goods and services typically purchased by consumers. This government figure is good for measuring economic activity for the country at large, but does little for individuals who have buying habits based on their age, lifestyle, and where they live that are different from the typical consumer’s. If you spend a lot on goods and services with high inflation rates, such as college and medical expenses, the CPI significantly understates the impact that inflation is having on you.
How does inflation erode purchasing power?
Most consumers don’t understand how damaging inflation can be over long periods of time on their purchasing power. One dollar today simply doesn’t buy as much as it did in 1970 and will buy even less 30 years from now. If you long for the days in which you could buy a Coke for a nickle, you know exactly what were talking about.
Inflation has averaged about 3% annually from 1926-2007. Three percent may not seem like much, but it can significantly erode your purchasing power over long time horizons. Take for example the impact a 3% inflation rate can have on a fixed annual income of $100,000 over a typical 30-year retirement. Your money would be worth 14% less in five years and in 30 years, the purchasing power of your income would be reduced nearly 60% to $40,101.
There’s a good chance that the rate of inflation you will experience in retirement will exceed the long-term average of 3%, simply because goods and services that you will be purchasing won’t resemble what the typical consumer is buying in the CPI aggregate. Medical expenses in particular are likely to be significantly higher portion of your overall spending. A recent estimate from the Centers for Medicare & Medicaid Services suggests medical inflation may be as high as 6.9% annually over the period 2006-2016.
What asset classes keep pace with inflation over the long run?
Despite the risk inflation can pose to retirement savings, the natural tendency for many retirees is to protect their investment assets by investing conservatively. As a result, many retiree’s portfolios are largely allocated to bonds and cash with minimal exposure to stocks. History shows however, that of these three asset classes, stocks were the only one to provide significant growth after accounting for inflation.
It is important to consider your return after factoring in inflation. Government bonds historically have returned very little after inflation, and cash fared even worse. Having exposure to stocks makes sense to help keep pace with inflation and protect your purchasing power.
There are other asset classes that could help with keeping pace with inflation as well, such as Treasury-Inflated Protection Securities, or TIPS.