The recent surge in inflation seems to have caught everyone by surprise. Considering that anyone alive today not born before 1960 has never really experienced high inflation as an adult, you could say we had become complacent about it. Though the shock of higher prices is real and can be problematic for many people, the more significant threat is what it can do to your purchasing power over time. The failure to account for that threat in your long-term planning can be potentially devastating to your finances.
Most people think about inflation in terms of higher prices on the grocery shelves and at the gas pump. While that is a real affect of inflation, it has to do with what people are spending today. Those are what economists refer to as “nominal dollars,” the money sitting in your bank account right now. But the money you will be spending 10 and twenty years from now is based in “real” dollars, which is the value of your money, or purchasing power, after accounting for inflation. Economists refer to that as the ”money illusion”—the belief that money has a fixed value without consideration for inflation.[i]
Inflation Reduces Purchasing Power (Real Dollars)
Inflation reduces your purchasing power over time. That means a dollar today will be worth less in the future. This can be especially harmful for people near or in retirement. Even at three percent inflation, you can lose half your purchasing power over a 23-year period. (To calculate how long it will take to reduce your purchasing power by half at any inflation rate just divide 72 by the inflation rate.)
Higher inflation, such as we have experienced in recent months, could cut it even faster. For example, a seven percent inflation rate would reduce your purchasing power by half in just over ten years. To put it in real terms, that means the same amount of money it takes to buy two Thanksgiving turkeys today would buy you just one in ten years.
Inflation Reduces the Value of Savings
If your savings cannot keep pace with the rate of inflation, you could lose even more purchasing power. When the inflation rate exceeds the savings interest rate, it erodes the value of your savings. For example, the current average interest rate on savings is below 0.3 percent, but the annual CPI for 2020 was 2.3 percent.[ii] Even though you see your savings account credited with interest each year, it is actually losing two percent of value due to inflation.
Fortifying Your Finances Against Inflation
Understanding the money illusion is critical because it can play tricks on you when making long-term financial decisions. Not accounting for the impact of inflation on future spending plans, investment strategies, and all the ways you expect to grow and preserve your assets for lifetime income sufficiency, can result in losing ground when you think you are on target.
Here are key aspects of your finances that could be negatively impacted by the money illusion:
Fixed Income Investments: Older investors tend to seek out low-risk investments such as bonds because they like the stable income. In our opinion, the low-yielding bonds of today are losing value due to inflation. Not only does inflation negatively impact the price of bonds, but also the future value of cash flow generated by bonds.
Variable rate debt: As interest rates rise, the cost of variable-rate debt, such as credit cards and adjustable-rate mortgages (ARMs), will increase. Now may be the time to consider freezing your debt costs by converting your variable-rate debt to fixed-rate debt. Fixed mortgage rates are still near historic lows, so the timing on that couldn’t be better. For credit card debt, consider paying it off as soon as you can or replacing it with a fixed personal loan.
Insurance coverage: Your home insurance may not cover what you expect. Home values are increasing quickly and if your insurance protection isn’t keeping pace, the coverage could fall short of your needs. Review your home insurance along with other insurance such as life and long-term care to ensure the protection is keeping pace with your needs.
Retirement savings: Neglecting to account for inflation can be detrimental when planning for your retirement. For example, if at age 40 you projected a need for $50,000 annually starting at retirement without adjusting for inflation, a steady rate of 3% inflation would reduce its real purchasing power to less than $25,000 at age 65.
While it may seem that inflation has just arrived, it has actually always been with us. Even if it settles in at 2% or 3%, it will have a negative impact on your future savings and purchasing power. Let the increasing prices at the gas pump be a reminder to consider their impact on your long-term finances.
Accounting for Inflation in Your Financial Plan
We believe inflation remains a constant risk for investors. At URS Advisory, we help our clients via MoneyMatch navigate this risk by working potential price increases into their financial and retirement income plans. We do this at each review so there aren’t any surprises that upset the financial balance of their lives. lf you are in need of a financial ally who will help you protect against these and other risks in your life, we encourage you to reach out to us today.