The consumer inflation rate hit an 18-month high in February, driven mainly by higher food and energy prices. But few economists think the longer-range inflation rate is heating up-- there’s still too much slack in the labor and housing markets.
Continue Reading Below
Over the long haul, inflation is a potential threat to retirement security, since a well-constructed plan looks out over a 25- to 30-year horizon. Yet inflation protection isn’t baked into nearly enough retirement plans, according to a new survey by the Society of Actuaries.
The study found that 72% of pre-retirees--and 55% of retirees--have a strategy to protect themselves against inflation in retirement. But the percentages probably are too optimistic, according to Steve Vernon, a prominent retirement educator and co-author of the report. “That’s higher than my experience talking with people at the seminars I teach. I think, there’s a say/do gap there, where people say they’re planning for inflation, but they’re not.”
“Other studies show that only half of pre-retirees have even calculated the amount of money they’ll need for retirement,” he adds. “So if that’s true, there’s no way 72% have thought about inflation.”
Vernon’s on the money there; the new 2011 Retirement Confidence Survey from the Employee Benefit Research Institute shows that just 42% have tried to calculate how much they’ll need to live comfortably in retirement.
Inflation poses several retirement challenges. Health care is a major area of expense and risk in retirement, and those costs are rising about four times faster than overall inflation. Meanwhile, sources of guaranteed income are faltering. Social Security is replacing a smaller percentage of income due to the increasing full retirement age implemented in 1983, rising Medicare Part B premium deductions and more Social Security income subject to income tax. The near-disappearance of traditional defined benefit [DB] pensions in the private sector also hurts retiree purchasing power.
Here are four ways to add inflation protection to your retirement plan:
Social Security provides important inflation protection. It’s one of the few retirement benefits around with a built-in cost-of-living adjustment [COLA), which is made using a formula set by federal law. Working at least until your Normal Retirement Age (currently 66) boosts your odds of receiving higher lifetime payments, and you’ll receive all the COLA adjustments from the intervening years.
The current yardstick used to measure consumer prices--the CPI-W--didn’t yield a COLA in 2009 or 2010 due to low inflation. However, the Congressional Budget Office [CBO] forecasts that a 1.1% COLA will be made in 2012, a 1.2% raise in 2013 and average increases of 2.1% from 2014 through 2021.
That’s the good news. Here’s the bad: deficit reform proposals call for changing Social Security’s cost-of-living adjustment [COLA] formula by adopting a new “chained CPI” that takes into account “substitution purchases” consumers make to avoid high prices. If adopted, the “chained” CPI is expected to rise 0.3% less annually than the CPI-W.
Model your retirement portfolio to allow for an annual withdrawal rate of 4%, plus an additional bump for inflation starting in year two of retirement. Adjust that plan only if necessary to preserve assets in the event of a severe bear market.
My Reuters colleague John Wasik offers excellent recommendations on how to protect your portfolio from the potential ravages of inflation, including the use of Treasury Inflation-Protected Securities and higher-yielding global bonds.
An income annuity can protect against inflation if you purchase one with a cost-of-living feature that provides automatic increases in payments indexed to inflation. I like income annuities — otherwise known as Single Premium Income Annuities — as a way to assure that you can meet all your living expenses in retirement. Here’s a good way to think about it: Start with your total monthly expenses, and subtract your expected Social Security and any other guaranteed income source, such as a defined benefit pension. The gap amount is what you could fill with an inflation-indexed income annuity.
Long-term care insurance should be purchased with a feature that adjusts daily benefit payments annually to protect against escalating nursing care costs. An annual 5% compound growth option is typical, and can boost the benefit value of a long-term care policy significantly over time. The American Association for Long-Term Care Insurance calculates that a policy bought in 1995 by a 55-year-old couple with a $150 daily benefit amount and a 5% compound growth option would grow to a $508 daily benefit by 2020, when they’re both 80 years old.
Continue Reading Below