With inflation missing in action from today’s economy, younger retirement savers may be surprised to find that their future retirement costs much more than they think it will. One reason is that inflation rates for the last couple of decades have been low by historical standards. Another is that retirees typically spend more on health care, and health care inflation rates have generally been significantly higher than overall inflation.
The recent quarterly survey of professional forecasters by the Philadelphia Federal Reserve Bank forecasts inflation over the next ten years will average 2.15% annually, significantly less than the 3.22% average from 1913 to 2013. Many observers, such as Marc Sarner, president of Wake Up Financial and Insurance Services in San Marcos, Calif., think it's more likely rates will return to the norm and, at least for a while, go much higher. “I believe hyperinflation could be on the horizon,” Sarner says.
Even if recent inflation of about 2% persists, a lifestyle that costs $100,000 today will, in 30 years, cost $181,000, notes Byron Ellis, a financial planner at United Capital in The Woodlands, Texas. And if inflation accelerates to 4%, about the historical average, the future requirement jumps to $324,000. “If someone thinks all they need is $100,000, they’re going to run short,” Ellis says.
Because most young savers today have never lived in a high inflation environment like the 1970s and 1980s, when annual inflation sometimes reached double digit percentage, inflation may not seem like a serious concern, Ellis says. “The fact that we’re not worried about it scares me,” he says.
Another inflation-related concern revolves around the fact that retirees spend more on healthcare than younger people. “Someone younger than 65 spends 9% of their income on medical expenses,” Ellis says. “Over 65, you spend around 13%. This is one expense that jumps up dramatically when you retire.” And, health cost growth has been two or three times the rate of the overall economy, suggesting that future retirees will spend even more on health than today’s retirees.
Inflation is more manageable when people are still working, because wages and salaries typically adjust with inflation, notes Kathy Kraeblen, a senior wealth planner with PNC Financial Services in Raleigh. However, with the exception of Social Security, which typically has annual cost of living adjustments, few guaranteed sources of income rise with inflation. “It is up to the retiree to factor inflation into their plans,” Kraeblen says.
Advisors say the best way to beat future inflation is to save as much as possible, as early as possible. Automatic payroll deductions have been shown to be the most effective way to build up individual retirement savings accounts. To increase the likelihood that the money in those won’t be devalued by inflation, experts recommend investing primarily in equities rather than bonds. Stocks have historically produced returns comfortably in excess of inflation. “With interest rates on bonds and other forms of fixed income currently very low, if those rates are locked in to someone's retirement plan while inflation increases, the retiree will face a loss of purchasing power,” Kraeblen says.
Another approach is to invest in a Roth IRA or 401(k), which allows tax-free withdrawals after retirement, in exchange for paying taxes on contributions now. It’s easier to pay taxes when you are employed, Sarner notes, and current tax rates are historically low. He advises paying taxes on a Roth contribution today rather than delaying them with a conventional IRA or 401(k) contribution. “Bite the bullet now,” he says. “Taxes are not going to go down.”
To help with the health costs issue, Ellis recommends savers consider putting money away in health saving accounts or HSAs. Most HSA contributors plan to take the money out the same year they put it in, Ellis says, but the accounts can also be used to accumulate funds to be withdrawn later, again without paying taxes, to pay qualifying medical expenses. Meanwhile, contributions can grow from investment returns. “That can be hundreds of thousand of to dollars by the time you retire -- tax free money you can spend for medical expenses,” Ellis says.