Inflation is at historically low levels, checking in at 1.4% for the 12 months through September of 2020, according to the U.S. Department of Labor. This is below average rates over the past 20 year and since the end of World War II.
Yet even at these historically low levels, inflation is still a key financial planning issue for your clients and prospects.
Inflation and Retirement Risks
Jeff Bush, president of Informed Family Financial Services, says, “Inflation is by far the biggest hurdle our clients face in retirement. Even using a modest inflation rate in our income projection models, purchasing power can erode quickly, especially when looking at a 20-plus year retirement.”
It has been said by many that inflation is the single biggest risk factor in retirement, bigger than the risk that retirement savers might experience losses on their investments. Advisers know that even a small amount of inflation can erode a client’s purchasing power over a relatively short period of time. Using the rule of 72, a 3% annual rate of inflation would cut purchasing power in half in 24 years. This is not a terribly long period of time for a person to spend in retirement. And while the current level of inflation is well below 3%, this is, historically, a fairly normal level of inflation.
Many of the things that retirees spend money on generally increase in price faster than the general rate of inflation. Examples include the cost of long-term care and the cost of prescription medicines. Cost of living increases for Social Security do not always keep up with the true cost of inflation for retirees. As an example, the cost of living increase for 2021 is a paltry 1.3%.
College Costs and Inflation
As those who are saving for college for their kids know all too well, the cost of college continues to rise. The cost of college has been rising at roughly double the rate of inflation over the past 30 years. Even the disruptions in on-campus learning from the COVID-19 pandemic have not provided much relief.
The COVID-19 pandemic has seen a demand for housing in many suburban areas that has outstripped supply for much of 2020 as many people seek to escape crowded urban areas. This, combined with historically low interest rates, has served to drive up housing costs in many areas so far in 2020.
While this inflation in housing costs may or may not last, this could have an impact on clients if they are looking to buy a new home.
Implications for Investors
Whether your clients are retired or approaching retirement, or if they are saving for other financial goals, their investments are a key tool in staying ahead of inflation. Investments are impacted by inflation in a number of ways.
Investments in cash, such as in money market accounts or similar interest-bearing investments will generally lose ground to inflation due to their relatively low interest rates.
Newly issued debt securities will reflect higher interest rates that are generally brought on by increased inflation. However, existing bonds could experience a decline in value due to increased interest rates amid increased inflation.
Stocks generally are a good way to counter inflation. However, their valuations can be impacted by inflation as well. Rising costs can hurt the bottom line of some companies. Rising interest rates can reduce profits through higher debt costs.
You will always want to have your clients in a mix of investments that is aligned with their risk tolerance and their investing time horizon. Clients at all stages of life will need some level of protection from inflation as well.
In the case of clients who are retired or approaching retirement, it's important that their investments reflect an asset allocation that offers the opportunity for them to stay ahead of inflation, reducing their risk of outliving their money in retirement.