One of the ways 2009 made history was by having the most sustained episode of deflation since the 1950s. As the year progressed, however, it was clear that inflation was making a comeback. This emerging trend should be a reminder that planning for inflation is critical to your retirement savings plan.
How inflation affects retirement savings
You still see articles wondering if a million dollars will be enough for retirement. Increasingly, though, new generations should regard the premise that a million dollars is adequate for retirement as a quaint notion.
Given the historical average inflation rate of 3.75% a year, by the time a 25-year old today reaches 70 years of age, he would see inflation turn that million dollars into the equivalent of $190, 781 in today’s dollars. All of a sudden, that doesn’t sound like such a lavish retirement nest egg, does it? Clearly, any retirement savings target has to factor in the effects of inflation over time.
Factoring inflation into a retirement savings plan
Here are some tips for factoring inflation into your retirement savings plan:
- At an average annual rate of 3.75%, inflation will double approximately every 19 years. Use this as a rule of thumb to figure out how many times your cost of living will double by the time you need the money.
- Don’t use your retirement date as the endpoint for your retirement planning. Remember, you could easily live another 20 years or more in retirement — time enough for your cost of living to double yet again.
- Inflation may vary greatly from year to year, but keep that 3.75% average in the back of your mind before locking in any certificates of deposit (CDs) or any other long-term investments. Also be sure to consider the impact of taxes. If you’re looking for a “safe” investment, it’s currently better to keep your bank deposits short and flexible — e.g., in a high-interest savings account or money market account — until bank rates recover.
- In the long run, you’ll need to consider investing more aggressively to protect your nest egg against the devastating effects of inflation. Without the higher returns offered by stocks and bonds, it will be virtually impossible to outpace inflation.
Because of the compounding effect of inflation over time, failing to account for inflation in your retirement savings plan can be as devastating as losing more than half of your money. However, if you get an early start and make sensible investments, you can get the power of compound interest rates working for you rather than against you.