Will inflation drain a retiree’s savings sooner than expected? Running the numbers

New research from SmartAsset highlights the harmful impact that inflation has on an individual’s retirement account, demonstrating that an increase of even a couple of percentage points over the long term can drain a retiree’s savings much sooner than anticipated.

The study considered three hypothetical retirees facing varying inflation rates per year and compared how their retirement savings fared under the circumstances. Susannah Snider, manager editor of financial education at SmartAsset, told BenefitsPro that the study shows the severe impact inflation can have, providing crucial context during a period of high inflation. In the United States, consumer prices rose 8.3% in August over the previous year.

“For retirees, or aspiring retirees, looking at this study, it’s worth noting the impact inflation can have on their savings and taking stock of ways they can reduce their cost of living or tamp down on their personal inflation rate,” Snider said. “Bottom line: High inflation can have a major impact on your financial plan and the longevity of your retirement savings.”

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In the study, Retiree A experiences inflation of 2% per year, Retiree B experiences inflation of 4% per year and Retiree C experiences inflation of 6% per year. The study aims to examine the profile of a typical retiree. For instance, each of the retirees has the same financial picture at the outset, including $500,000 in savings for retirement. At the start, each retiree spends $50,595 per year or $4,216 per month, numbers based on the average that someone spends in retirement between the ages of 65 and 74, according to a Fidelity analysis. Those expenses – and withdrawals from their retirement accounts – rise in subsequent years based on their individual inflation rates.

Meanwhile, each retiree is invested in a diversified investment fund returning 5% per year, and Social Security covers 39% of expenses for the retirees, a figure based on Social Security Administration data. Each retiree begins to withdraw funds from their retirement fund at age 65.

Based on those circumstances, Retiree A’s savings would last 22 years at 2% inflation, Retiree B’s savings would last 17 years and nine months at 4% inflation and Retiree C’s savings would last just 15 years and two months at 6% inflation.

Retiree A’s experience is most in line with long-term averages, according to SmartAsset, which noted that year-over-year inflation averaged 2.3% from 1991 to 2019, according to Pew Research. Retiree B’s conditions align with the experience of those who retired in the 1970s and saw an inflation average of approximately 4% over a 30-year period. Meanwhile, the high inflation rate encountered by Retiree C would be very high historically, but also remains well below the high inflation rate the U.S. currently faces.

The study not only serves as a warning to underline how high inflation can erode retirement savings, but it also highlights the potential value of considering investments that could help protect portfolios against inflation – or at least mitigate its impact.

Inflation-proofing a portfolio

“The basic idea behind inflation-proofing your portfolio is this: If inflation is at 2%, for example, your portfolio needs to return at least that much to avoid declining in value over time,” Snider said. “In order to protect your purchasing power, you may choose to invest in higher-risk investments.”

Snider said that the individual risks associated with attempting to inflation-proof a portfolio will depend on specific investments and how diversified the portfolio is across asset classes.

“For example, investing in U.S. stocks carries different risks than investing in Treasury Inflation-Protected Securities, which are U.S. Treasury securities that carry a principal value indexed to inflation,” Snider said. “Ultimately, you’ll need to have an eye toward diversification and time horizon. And because these investments can come with varying degrees of risk, it can be helpful to speak with a financial advisor to determine what level of risk your portfolio is able to withstand.”

The study notes that retirees also can strategically withdraw funds from certain accounts first during periods of high inflation to avoid locking in losses or missing potential investment returns.

“Inflation is a beast,” the study concludes. “Even an increase in a percentage point or two over the long term degrades savings quickly. And while inflation is generally a macroeconomic trend, which is difficult to control on an individual level, working with a financial advisor may help retirees identify strategies they can employ to prepare for it.”