NEW YORK (MainStreet) – It’s February: Time to stop making excuses about the holidays and set your New Year’s financial strategy in motion by boosting your savings rate to offset inflation.
Inflation was gentle in 2010, with the Consumer Price Index up about 1.5%and the “core” inflation rate, a steadier figure that ignores volatile food and energy costs, up only 0.8%. Inflation typically averages around 3% in the U.S., so Americans got off easy last year. That’s good, because wages rose by only about 2%.
Financial experts often tell us that our savings should go up each year to keep pace with inflation. If you put the same sum aside year after year, its real value, or purchasing power, would shrink as inflation makes goods and services more expensive over time.
If you’d saved $100 a week last year, you would be wise to save $103 a week this year, assuming a 3% inflation rate.
Since core inflation was just 0.8%, you could take it easy and boost your savings to just $100.80 a week, but it wouldn’t make sense to use the core rate to guide your savings plan unless you’d figured a way to live without food and energy. Using the broader CPI, you’d boost your savings to $101.50 a week.
But is that enough? To work best, a savings strategy should be matched to various savings goals. Inflation is not a big factor for a short-term goal like building cash for the out-of-pocket costs of the car you’ll buy in a few months but inflation is a very important factor for long-term goals like college and retirement.
In recent years, college costs have gone up at about twice the inflation rate. So, if you have a baby who will start college in roughly 18 years, you should probably assume that college costs will go up by 5% or 6% a year, perhaps more. Use the BankingMyWay College Savings Plan Calculator to estimate future costs. Note that it assumes a 6.5% college inflation rate, but you can change that to explore a range of outcomes.
For most people, retirement is the other big long-term savings and investment goal. Again, neither the regular CPI nor the core rate will necessarily reflect the way your own cost of living will look in retirement.
Older people, for example, may spend more on health care than young and middle-aged people do. Health care costs generally rise faster than inflation, but it’s very hard to estimate what your costs will be in 20, 30 or 40 years. Medicare has a serious long-term funding problem, and even if it didn’t, it does not cover all of one’s medical expenses. So it will pay to build savings for that in a safety margin.
Back in the '90s, many people who were saving for long-term goals assumed that investment returns would more than offset inflation, making it easy to build a big nest egg. That seemed sensible when the stock market was on a roll, but stocks haven’t done well in the past decade. Bonds have performed well, but much of that was driven by rising bond prices as interest rates fell, and now that process is likely to reverse.
The bottom line is this: If you’re trying to build a big nest egg, you can’t count on dazzling investment returns, which makes it all the more important to boost your savings rate as much as possible. Savings should increase by at least 3% a year.
Use the BankingMyWay Retirement Income Calculator to see how your savings plan will turn out. Checking the box labeled “to increase deposits with inflation” can improve your outcome dramatically.