When you retire, there's likely a good two to three decades of living to look forward to. But the amount your dollar buys in the first year you retire won't be anywhere near as much as the last. A retiree who socked away enough to get $1,000 per month in 1990 would be getting the equivalent of $550 dollars now, according to the Bureau of Labor Statistics, using consumer price index data.
Average inflation rates in the U.S. have been about 3.2% over the last century; pretty low by international standards. That figure masks a lot of variance, though. Over-40s might remember the 1970s, when inflation rates hit double digits. Three to five percent per year has been the rule for the last two decades, so it's probably prudent to assume something at the upper end of that range.
That implies a return on investment of at least 4-6% per year, in addition to whatever income is generated or saved for. That is, one should assume that the absolute number of dollars taken out of retirement savings will go up by that amount each year. So the first year one might take out $10,000, the next year $10,500, et cetera. Accordingly, here are some strategies for investors, as well as financial advisors, might want to adopt.
Rent Your House
If you own your house, renting part of it out can be a nice inflation hedge because rental prices reflect local inflation. If the location is good, raising rents over time won't impact getting a tenant.
More senior citizens are renting out space out of necessity. The Harvard Joint Center for Housing Studies published a report that showed that in 2010, more than 30% of homeowners between 65 and 69 years old still had mortgage debt. If you're retired, the double whammy of inflation and interest makes renting out that spare bedroom a more attractive option. (For more, see: How to Rent Your Home so You Can Pay Your Mortgage.)
Can you use your house to save for retirement? Probably not. There is a huge difference between monetizing real estate that you own and investing for retirement. In order to turn a profit on a property it's necessary that its value increase faster than inflation and the interest rate on the loan, which might be an additional 3-5% at least. So one's real estate would have to gain value at rates approaching 6% every year at a minimum, and more likely double digits. Outside of a real estate bubble, that isn't likely. There are many good reasons to buy a home — building equity is one — but investing for retirement is probably not one of them. (For more, see: The Complete Guide to Becoming a Landlord.)
Treasury Inflation-Protected Securities, or TIPS, are a kind of government-backed bond introduced in 1997. Unlike conventional treasury bills, TIPS have an adjustable principal, linked to the consumer price index, and a fixed coupon rate. That means that as inflation rises (or falls) the amount of money that goes to the holder varies with it.
On the plus side, there's no danger that inflation will get high enough to make them money-losers, unlike conventional bonds. A coupon rate of 3.5% does no good if inflation reaches 4%. The risk, though, is when inflation is negative or extremely low. Deflation doesn't happen often – the last major deflationary period in the U.S. was the Great Depression. Even the Great Recession didn't manage a negative rate — the closest was in 2008, when inflation hit 0.1%. A very low inflation rate can, however, push treasury yields into negative territory as investors panic and rush to the relative security of T-bills. (For more, see: Shield Your Portfolio from Inflation.)
Annuities can offer inflation protection, depending on the type. An annuity is basically "retirement insurance." You pay a premium and at the end of a certain term you get a fixed monthly payment. (For more, see: An Overview of Annuities.)
Fixed annuities generally win out here; the combination of lower fees and the security that comes with not having to worry about the value of the underlying assets makes them better for most people.
Variable annuities are annuities that offer higher returns if the market does well. One can continue to make contributions after retirement, and sometimes they are taxed at a lower rate. They have higher fees, though, and are complex investments. (For more, see: Inflation-Protected Annuities: Part of a Solid Financial Plan.)
Mutual Funds, Stocks and ETFs
Of course there's always just traditional investing for income, putting money into funds, stocks, or exchange-traded funds and living off the returns. If one invested just $1,000 in the stock market in 1994, in a fund that tracked the S&P 500, the net worth would be $3,240, a return of 324%. Keeping up with inflation over that period would only need a return of about 160%.
Funds, stocks and ETFs are all very liquid, and even if one accounts for capital gains, the tax rate is considerably less, about 20% at the high end, than that for ordinary income. Dividends are taxed at the ordinary rate, but long-term capital gains — which is anything held for a year or more — are not.
In retirement, though, the concern is usually providing a stream of income, rather than growing the assets. And as the saying goes, "timing is everything." Anyone who put money into that S&P 500 fund in 2003, when markets hit lows in the wake of the dot-com bubble and the 9/11 attacks, would have lost money by 2008. Had they pulled out in late 2007 they'd have doubled their investment. The difference is only a few months. Many soon-to-be-retirees had to keep working in the wake of the financial crisis because so much of their wealth was tied up in stocks. (For more, see: Will You Have to Delay Your Retirement?)
Then we have the old standbys: defined benefit plans and Social Security. Social Security is a "fixed income," but it has a cost-of-living adjustment. And delaying retirement can go a long way too: for a worker making about $50,000 (the median income) who is about to retire and is 65, the benefit is get $1,302 per month. But if they delay until they are 67 that check goes up to $1,556. (For more, see: Delaying Social Security Can Add Up.)
Social Security by itself isn't much, of course, but in combination with savings and a 401(k) plan, it can help a lot.
Defined benefit plans (if you're lucky enough to have one) often structure benefits according to the last few years of salary. Delaying retirement can boost the monthly amount, providing a further hedge against inflation even if the check is a fixed number.
The Bottom Line
There are several strategies to managing inflation in your or a client's retirement savings. Most likely, a combination of the above strategies will be employed to ensure that purchasing power is protected and savings drawdown doesn't happen too fast.