Inflation — one of retirement's biggest risks — is back

WE’VE ALL SEEN THE HEADLINES — inflation is on the rise. The Consumer Price Index (CPI) measured the increase in the average cost of goods and services at 6.2% for the 12-month period ending October 2021.¹ That number can come as a bit of a shock for folks used to a decade of inflation mostly below 2%.²

Whether or not — as some economists expect — this current bout of inflation is temporary and driven largely by pandemic-related factors, “it’s a useful reminder of the importance of factoring inflation’s effects into your retirement planning,” says Surya Kolluri, managing director of thought leadership for Bank of America’s Retirement & Personal Wealth Solutions.

The risk to retirees

Most people notice inflation when they shop: Things cost more, from clothes, gas and groceries to appliances, cars and even homes. If you’re working, you can budget for that — and your salary might also rise with inflation. But for retirees and those nearing retirement, inflation has more serious financial consequences: Over time, rising prices can significantly reduce your spending power when you’re living on a fixed income. For instance, if the current 6.2% inflation rate persisted for five years (experts don’t expect that it will), it would whittle the buying power of a $1 million cash account down to $740,248.30. But even a hike as small as 2% or 2.5% in inflation can have a sizable impact. See the chart above.

Retirees will get a 5.9% cost-of-living adjustment (COLA) to their Social Security benefits in 2022³ — the largest increase in 40 years — to help them cope. However, it’s unlikely that will offset all rising costs.⁴ The price of healthcare, for example, is increasing even faster than the CPI, and you’re likely to see a spike in Medicare premiums and deductibles as well. So it’s not surprising that 59.1% of people 55 and up are extremely or very concerned about the effect of inflation on their retirement plans, according to an October 2021 CivicScience poll.

Plan ahead to offset inflation

“We need to be financially prepared for 100-year lives,” says Kolluri. “When you consider how long your retirement is likely to last, having a plan to help you deal with inflation’s effects is a must.” If you’re retired or nearing retirement, here are four approaches you can discuss with your advisor.

Delay claiming Social Security benefits. While you can begin collecting Social Security at age 62, waiting until age 70 could raise your lifetime monthly benefits by 76%.⁵ This is one way to hedge against the potential for inflation, but it’s not a one-size-fits-all strategy. Considerations like your health and expected longevity, the age difference between you and your spouse, how much longer you may want to work, other sources of income and tax issues might all play a role in helping you determine the best approach, Kolluri says. Your advisor can help you run the numbers and create a Social Security claiming strategy that works for you.

Invest for growth and rebalance regularly. “Given today’s low interest rates, coupled with rising inflation, retirees may want to allocate more of their assets to equities in the near term to outpace inflation,” suggests Joe Curtin, head of CIO Portfolio Management, Chief Investment Office, Merrill and Bank of America Private Bank.  “Equities may offer an opportunity for the growth of your assets to exceed the rate of inflation as we wait for higher yields and a steeper yield curve in fixed income markets.” (The yield curve steepens when the difference between short-term and long-term rates increases.) You may also want to consider more conservative investments that aim to counter the effects of inflation on your savings, such as Treasury Inflation-Protected Securities (TIPS) or Series I savings bonds.

“We think inflation will run higher for longer, and that is not always a bad thing,” says Curtin. But it makes rebalancing your portfolio periodically more important than ever. Doing so allows you to maintain the proper mix of asset classes that match your objectives, time horizon, liquidity needs and risk tolerance. “We will encourage clients to rebalance their portfolios again as yields normalize and/or the yield curve steepens,” he adds.

Consider the role of annuities. These contracts issued by insurance companies can be indispensable in your retirement toolbox, says Kolluri. When you invest a portion of your retirement assets in an annuity, you are provided with a consistent stream of fixed income for life or for a period of time specified in the contract. “In combination with Social Security, that guaranteed income might give you the confidence to pursue a slightly more growth-oriented investing approach with your remaining assets,” Kolluri notes. Your advisor can help you understand the various types of annuities and what they can offer, as well as their risks. “Annuities are only one part of a larger set of asset allocations that might also include cash, equities, fixed income and, for qualified investors, alternative investments such as precious metals, real estate or commodities,” he adds.

Prepare for future long-term care costs. “If you look at the arc of human history, in spite of diseases, we have steadily increased longevity,” says Kolluri. “We need to be prepared for the costs associated with it.” In retirement, a 65-year-old couple with median drug expenses is likely to need $270,000 to cover their out-of-pocket healthcare costs.6 And considering that increases in the cost of healthcare tend to outpace inflation, planning ahead is key.

One strategy to help offset rising healthcare costs is to contribute the most you can to your health savings account (HSA) — but be aware that in order to open an HSA, you must be enrolled in a high-deductible health insurance plan and you can no longer contribute to an HSA once you sign up for Medicare Part A. HSAs let you carry over funds year to year and offer the triple benefit of pre-tax contributions, tax-free growth and tax-free withdrawals for qualified expenses. Eligible expenses include Medicare premiums, as well as long-term care premiums and services. (Please consult with your own attorney or tax advisor to understand the tax and legal consequences of establishing and maintaining an HSA account.)

Another option to consider is a life insurance policy with a long-term care benefit rider, which could potentially cover some healthcare costs while letting you leave a tax-free sum to your heirs.

Inflation isn’t something we can control, says Kolluri. “But there are concrete steps we can take to lessen its impact on our retirement security.” Discussing each of these strategies with your financial advisor and legal and tax professionals can help ensure that you’ll be able to afford the life you want in retirement, even when inflation boosts your cost of living.