Your Money Matters By Barry Feigenbaum: Thinking About Inflation

By Barry Feigenbaum

One of the risks we all face, especially those of us on a fixed income, is the loss of purchasing power that results from inflation. Inflation means that the cost of buying a particular set of goods and services takes an ever- increasing amount of money. The challenge for retirees is that most retirees have little opportunity to increase income from work throughout retirement to offset these cost increases. A typical retiree only has the cost of living adjustment (COLA) in Social Security to offset price increases. These COLAs are based on increases in the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). And, although CPI-W is unlikely to exactly match the cost of any retiree’s actual basket of purchases, the annual increase is a help for catching up with rising costs. 

There is a simple calculation to estimate very roughly your potential exposure to inflation. Last quarter we wrote about financial planning and noted that budgeting was the foundation of planning. To estimate the impact of inflation, we take that expense budget and eliminate any expenses that are fixed in amount. Examples of fixed expenses include fixed-rate mortgage payments, fixed-rate car loans, and certain types of life insurance premiums. Next, we subtract any retirement income streams that are adjusted for inflation. For many of us, that is just Social Security retirement benefits. That net number is simplistically how many dollars of your expense budget are exposed to inflation. 

Of course, your individual expenses in retirement will respond to price changes differently. Health care costs have their own dynamics; the cost of care and medicines are particularly vulnerable to price pressures and are likely to increase as baby boomers age. Rising food and energy prices always seem to be in the headlines. All our expenses respond to macroeconomic and product-specific supply and demand factors, and their prices adjust accordingly. 

I tell people to consider both annual and long-term inflation when assessing their retirement cash needs. We feel annual inflation every time we pay for our purchases. We remember last week’s price for gas or food. We get sticker shock when we go out to dinner in a restaurant. 

So, how do we deal with short-term price increases? One common response is to cut expenses someplace else. Maybe we reach into liquid savings such as an emergency fund to finance the increase. The challenge becomes dealing with these increases year after year on a fixed income. There are only so many things to cut, or there is a limit to idle cash balances. 

As a result, inflation becomes an even bigger challenge as price increases compound over time. People remember what things cost in their youth or how many bags of groceries they got for $50 when they were younger and how many they get today. 

How can we prepare for inflation? Advisors will tell us to invest in assets that they believe are responsive in an inflationary market; these can be real estate, stocks, or commodities. What about TIPS or Treasury Inflation-Protected Securities whose principal adjusts with inflation? You can think about a deferred annuity for your later years that you would “turn on” to generate more income in the future. You might build a funded account designated for later years to be withdrawn to offset rising costs. You might purchase some zero-coupon bonds to mature sequentially far into the future to mature and offset rising costs. The price today of ZCBs is substantially discounted based on time to maturity and interest rates. These bonds do not pay cash interest currently but instead accrue the value of the interest to the bond’s principal to be paid at maturity. You must be aware that investing in such ZCBs adds credit risk, which is the risk that the bond issuer will repay the full amount of the bond (including the accrued interest) at the bond’s maturity. This maturity may be 15 years away or even longer and is a meaningful risk in our ever-changing world. 

Regardless, we appear to have entered a period in which inflation is no longer minor. Even inflation at the Fed’s 2% annual target will have a significant impact on a retiree’s fixed income over a long period of years. We must include strategies in both our near-term and long-term planning to address the risk of purchasing power loss in retirement.

This presentation should not be used as a basis for legal, tax, or investment advice. In any specific case, the parties involved should seek the guidance and advice of their own legal and tax counsel and financial advisor. 

Barry Feigenbaum is a Certified Financial Education Instructor® with more than 40 years of financial services experience who has taught thousands of students in educational, corporate, and not-for-profit settings how to take control of their financial lives.