There are strategies to keep inflation from gutting your retirement goals

Inflation is described as the general increase in the prices for goods and services in an economy, with the result that each unit of currency buys fewer goods and services. The result is reduced purchasing power: Money doesn't go as far for people as in prior years. Although we tend to think of inflation as something that is very general, like the economy of the entire United States, it's possible to experience inflation in very small areas, like in gasoline, computer chips, food and so on.

The opposite of inflation is deflation, which is a general decrease in the prices for goods and services. Generally speaking, modern economies have tended to experience inflation. Periods of deflation have usually been associated with recessions or depressions.

The traditional way to measure inflation is by tracking the prices for a fixed basket of goods. For instance, a basket consisting of eggs, laundry detergent and clothing can be measured over time, generally months and years. Increases in the cost for the basket indicate inflation and decreases would indicate deflation.

The federal government calculates inflation in an official capacity; their calculations declare what the “official” inflation rate is. There are a variety of tools and calculations used to determine inflation but the one most commonly known is the Consumer Price Index, or CPI. The way CPI is calculated has changed over time, but it is generally a more complicated basket of goods approach.

The Federal Reserve uses inflation and employment data to determine what interest rates should be; as inflation picks up, they tend to raise interest rates in order to reduce inflation. Extended periods of very low unemployment can also cause inflation, and the Federal Reserve might increase rates in that case, too.

There can be a multitude of causes for inflation. At the most basic level, inflation can arise when supply and demand get out of balance, with too little supply or too much demand for a product or service. Another cause of inflation is monetary policy. In economies where money has been “printed,” inflation has been the result. This has been most spectacularly seen in the Weimar Republic between the World Wars and in Argentina and Venezuela in the last 50 years. In this case, excess money created excessive and artificial demand for products and services; prices rose (spectacularly) to bring demand back down into a more natural supply of goods and services.

In 2022, the United States, and the rest of the world, experienced a surge in inflation caused by a combination of factors:

• Large money supply from a persistent and prolonged period of low interest rates.
• Additional economic stimulus payments related to the COVID-19 pandemic response.
• Severe supply chain disruptions also due to the COVID-19 pandemic.
• A spike in commodity prices due to global anxiety over political tensions in Eastern Europe.

Global energy policies aimed at increasing “greener” energy have also contributed to the inflationary pressures.

It's generally taken for granted that inflation is “bad,” but it's important to acknowledge that most economists believe that mild inflation is preferable to deflation. This is often called disinflation – a persistent low rate of inflation. Of course, the definition of “mild inflation” is controversial and subject to debate.

Inflation is harmful primarily because it lowers consumers' purchasing power and consequently their standard of living. Inflation harms two groups of people in similar ways, but to different degrees:

• Those people actively earning a living.
• Those people on fixed incomes, like the retired and disabled.

Inflation is a problem for working people, especially middle- and working-class families, because the cost of all kinds of staples rise during inflationary periods, but almost always at a higher rate than wages increase. Since basic needs like food, fuel and clothing must be purchased as necessities of life, money is spent in greater quantities while wages stay stagnant. If wages do increase, it's generally through finding new work or starting a new business. The lag time on these kinds of changes can be large, resulting in much financial harm in the interim.

For those on a fixed income, persistently high inflation can seriously erode their financial status. In periods of high inflation, costs for basic goods keep climbing, but since incomes are fixed, one or both of the following have to occur to make up the difference:

• Savings are used to supplement income in order to afford basic necessities.
• If savings are not available, fewer resources will be consumed.

Neither of these outcomes is good for retirees. Savings need to last for a lifetime; if larger or more frequent withdrawals are made to overcome the effects of inflation, savings can be depleted too early. Needless to say, running out of savings late in life can be a tragedy. You might consider returning to work to make additional income, but this may not be feasible, especially if you've been retired for a lengthy period of time.

Since the effects of inflation are compounded, just like interest or investment gains compound over time, even a relatively “low” rate of inflation can have a catastrophic impact on the purchasing power of fixed incomes.

The chart below shows the purchasing power of a fixed income of $2,500 per month at various inflation rates and timeframes.

One of the simplest methods of preserving your purchasing power is to change your lifestyle habits. You can substitute many goods and services to lower the impact of inflation. Traveling by air or by car, vacationing abroad or cruising are all vacationing choices that can be customized to mitigate the effects of inflation. Downsizing to a newer, smaller home can not only free up equity that's trapped in your existing home, but the maintenance costs can be lower as well, as can the property taxes associated with your home. The equity that you capture from such a move can be used to increase the size of your nest egg.

Of course, there's a limit to how much substituting and downsizing you'll enjoy. You probably plan on a retirement of comfort, and anticipate greater choices rather than fewer, but some of these changes can allow you still enjoy retirement while watching your budget. Managing expenses is just one aspect of a plan to combat inflation.

One of the primary ways you can protect yourself against inflation in advance is by maximizing the size of your nest egg. It may sound trite and elementary, but the larger your nest egg in retirement, the more cushion you'll have if prices rise and eat away at your purchasing power. You would prioritize investment growth during your working career in order to achieve this. Deferring spending and maximizing savings during these years is key to this strategy.

Once you're retired, it's more difficult to mitigate the effects of inflation. You could potentially keep your money invested in higher-earning investments, but this is risky. The only thing worse than experiencing high inflation during retirement is taking large investment losses in your portfolio. Large losses in your retirement accounts during a period of high inflation could be a catastrophic double-whammy. If high-risk, high-reward assets should be minimized, this means that you need to find a way to maximize your earnings in retirement without exposing yourself to the dangers of volatility.

Traditionally, precious metals and other “hard” assets like real estate have been viewed as hedges against inflation. These assets have tended to rise when inflation increases. However, precious metals like gold and silver often have long periods of minimal investment gains (and sometimes long periods of losses), and they don't pay dividends or interest, so they may not be a useful option for retirees. Similarly, owning and managing real estate may be too complicated for many retirees. The tax consequences of real estate investments can also cause undue complications.

A strategy that takes advantage of the benefits of real estate may be to consider the use of real estate investment trusts (REIT). Since REITs pay a large percentage of their earnings out as dividends, they can supplement your income. Also, depending on the types of REITs you choose, their earnings may be positively impacted by rising inflation.

REITs are also exposed to market fluctuation and can lead to investment losses, so they should not be overly relied upon.

A better option may be to use indexed insurance products like fixed index annuities (FIA) and indexed universal life insurance (IUL). These products combine the best of traditional insurance assets (absolute safety of principal) with the potential for market-based investment returns.

These indexed insurance products allow you to base your interest rate on the performance of one or more indexes. Since markets like the stock market often rise along with inflation, being able to earn interest based on their performance can boost your earnings power well above the small, fixed interest rates that insurance products traditionally pay.

The best part of these products is that they remain guaranteed: They won't pay less than 0% in any year. In other words, unlike investing in stocks, bonds or mutual funds, you're protected from losing money, even if the indexes you use decline. This gives you the ability to “swing for the fences” trying to earn higher interest rates but eliminate the downside.

Another insurance-based strategy involves the use of permanent, or whole life, insurance. While these kinds of products aren't known for paying high interest, the fact that they do pay some interest and even dividends in some cases, can help your estate planning keep pace with inflation. If you've chosen your whole life insurance policy with care, you'll likely be able to use any dividends or interest you receive to purchase additional death benefits. These are often referred to as “paid-up additions,” and the best thing about them is that they increase the death benefit your policy will pay, but you don't have to apply for them. By using this benefit, you can continue to increase your death benefit, even if your health has declined and you wouldn't normally qualify for more insurance. By using this option, you can ensure that the money your life insurance policy eventually pays to your heirs will grow over time; this will counteract the loss of purchasing power due to inflation.

It can be perilous to ignore the potential harm caused by inflation. Your plan needs to start with the fact that inflation is not only possible but likely. You can counteract this harm during your chief earning and savings years by maximizing your nest egg. You can mitigate the dangers through your asset allocation and spending choices in retirement. It's very important to work with a financial professional who understands the dangers of inflation and is intimately familiar with the kinds of insurance products that can help protect you.