It's tempting to not get too worked up about inflation and its impact on your retirement plan. After all, CPI has been running at a fairly benign level of less than 2% for the better part of a decade. And in any case, how could such innocuous little numbers like 2% or 3% make a big difference in the success or failure of your plan? In actuality it can make quite a bit of difference:
One of the key reasons you should care about inflation in the first place is that if you've staked a decent share of your portfolio in fixed-rate investments like cash or bonds--as is only prudent to do leading up to and in retirement--higher prices on goods and services you need to buy will erode the purchasing power of your returns on those investments. Another way to think about it is if you've staked more of your assets in conservative investments as retirement approaches, that lowers the absolute return you're apt to earn on your portfolio, and inflation could take a big bite out of your earnings. If you're lucky to earn 5% on your money, you sure as heck wouldn't want to give up 60% of that gain, as you'd effectively do if inflation runs at 3% during your retirement years.
There's also the fact that inflation has been kicking up a little bit recently, and, more importantly, that inflation for older adults has tended to run higher than the general inflation rate. In large part that's because healthcare-related expenses are a bigger share of the average older adult's total household outlays, and those costs have been running about 70% higher than the general inflation rate.
You can defend against inflation in a couple of key ways. One is to embed direct inflation hedges like inflation-protected bonds in the bond portion of your portfolio; when inflation goes up, you get a little raise on the principal or interest coming from the bonds. But don’t stop there. At the risk of stating the obvious, those inflation-protected bonds only confer inflation protection upon the portion of the portfolio you've invested in them. Moreover, because the inflation adjustments you receive on those bonds are keyed off of the general inflation rate, not the inflation rate you personally experience, they may not reflect your actual purchasing experience. If you have a lot of healthcare expenses, for example, that will tend to push your personal inflation rate above the general inflation rate. We think the best way to help address that issue is to simply hold a healthy share of your portfolio in stocks throughout retirement. While by no means a direct inflation hedge--if inflation goes up by 3% in a given year, your stock portfolio is by no means likely to return the same--over time equities have provided the best long-run shot at out-earning inflation.