Inflation is well understood by most economists and investment professionals, but it’s usually not very clear to individual investors. That includes pre-retirees and retirees, who especially need to understand inflation’s potential impact on their ability to live on their terms during retirement.

Essentially, inflation measures how much more expensive the things you buy have become over time. As a simple example, consider an item with a price today of $1. If that same item costs $1.05 a year from now, its inflation rate over that period is 5%.

Broadly, inflation is measured by the average rate of change over time in the Consumer Price Index (CPI), a market basket of consumer goods and services. During the past 103 years, the CPI has risen by an annualized rate of 3.1%. Using that number, a $1 item in 1913 would now set you back about $23.

The effect of rising inflation can be viewed as either the erosion of purchasing power or as the growth of prices. While inflation rates are typically small over short periods of time, their impact can be severe over longer horizons—such as a lengthy retirement. Figure 1  shows inflation’s impact on purchasing power over various retirement horizons, using the annualized core inflation rate over the last 100+ years. At this rate, in 30 years, $1,000 would be worth the equivalent of $400 today.

Figure 1: Erosion of Purchasing Power

Figure 2  digs deeper into the CPI’s market basket of goods for the typical retiree. Among individuals’ ages 65+, the largest expense is housing—while healthcare (one of the bigger concerns among retirees) represents 13% of spending.

Figure 2: Components of Consumer Expenditures Ages. 65+

Figure 3  shows the inflation rate for these spending categories—how fast prices have risen for each type of expense. While core inflation has averaged around 3.1% per year, many other expenses are rising much more rapidly.

• Healthcare costs have risen by 5.2% annually. Going forward, they’re expected to rise even faster—6.5%, according to the PwC Health Research Institute.
• Housing costs—the biggest expenditure for consumers age 65 or older—have risen by 4.3% a year.

Figure 3: Inflation rates of Consumer Expenditures

The reality: Inflation overall has the potential to erode retirees’ purchasing power—while rapid growth in some of the biggest expense categories could potentially be devastating.

For example, Table 1  takes the average monthly costs of each of these components from the Consumer Expenditure survey and shows the impact of rising costs on future expenses. Monthly costs may differ by individual, of course–but the potentially severe impacts of inflation are quite clear:

Table 1: Growth of Prices of Components of Consumer Expenditures

When evaluating retirement income solutions, it is important to consider those that are specifically designed to mitigate inflation risks. Harnessing the long-term return potential of equities is crucial—especially given that intermediate-term government bonds have averaged only 4.2% per year, after taxes.  At that return, a 100% bond portfolio would grow less than projected healthcare and housing expenses–two of the largest expenses for a typical retiree.

Learn more now about Real Spend^®, our retirement income solution designed to mitigate inflation risks.

I. Source: Federal Reserve Bank of St. Louis Consumer Price Index for All Urban Consumers 1913-2016.

II. Source: Consumer Expenditure Survey from the Bureau of Labor Statistics 2014-2015, Age 65 and Older.

III. Source: Federal Reserve Bank of St. Louis Consumer Price Index for All Urban Consumers Components All available years.  Medical Trends is forecasted healthcare inflation from PwC Health Research Institute medical cost trends 2007-2017.

IV. Source: Inflation rates come from the Federal Reserve Bank of St. Louis Consumer Price Index for All Urban Consumers Components All available years.  Medical Trends is forecasted healthcare inflation from PwC Health Research Institute medical cost trends 2007-2017.  Current monthly costs come from the Consumer Expenditure Survey from the Bureau of Labor Statistics 2014-2015, Age 65 and Older.

V. SBBI Ibbotson data for Intermediate-Term Government Bonds from 1926 – 2016.  Taxes are applied considering the highest Federal Marginal Tax Rates for 2016 for long-term capital gains.  No state or local taxes are accounted for.