Protecting Your Retirement Income from a Silent Killer

By Rick Henderson, CPA, CFP®, AIF®
In talking to my clients about planning for their retirement income and building portfolios for their retirement, I find that many of them are concerned about stock market volatility and protecting what they have built over the years. What I rarely hear them mention is the silent killer of retirement income purchasing power: inflation.  
What can you do to prevent your retirement income’s purchasing power from this silent killer?
Inflation is the rise in the cost of goods and services every year. The Federal Reserve has a target inflation rate for our country, currently about 2%. A modest 3% inflation rate does not seem like much from year to year. But, with people living longer, the time spent in retirement is getting longer and after 20 years, a 3% inflation rate can reduce the purchasing power of $100,000 to $55,368. Looking at it in reverse, if there is 3% inflation for 20 years, it will take $180,611 to purchase the same goods and services in 20 years that $100,000 buys today.
Inflation, Consumer Prices for the United States
Inflation, Consumer Prices for the United States
Shaded areas indicate U.S. recessions.
Inflation for 2016 was 2.11 As you can see from the “Inflation, Consumer Prices for the United States” chart, the annual inflation rate for any given year can vary greatly. Currently, we are in a low inflation environment, with the average annual inflation rate for this decade remaining below 2% thus far.  Historically the average inflation rate has been higher over longer periods of time.  
Average Annual Inflation by Decade
Average Annual Inflation by Decade ©2015

As you can see from the “Average Annual Inflation by Decade” chart, the average annual inflation in the United States since 1913 is more than 3%. If the inflation rate during your retirement exceeds the 3% mentioned above, inflation’s potential impact on your retirement will be even greater.  
So, what are some ways that you can you protect the purchasing power of your retirement income from inflation?  
The first step is to understand the difference between nominal and real rates of return. The nominal rate of return on your portfolio is the amount it actually returns. The real rate of return is the effective amount your portfolio grew after adjusting for inflation, and is calculated by the following formula:
Real Rate of Return = ((1+Nominal Rate of return)/(1+Inflation Rate))-1
To keep things simple, you can approximate the real rate of return by taking your nominal rate of return minus the inflation rate2:
Approximate Real Rate of Return = Nominal Rate – Inflation Rate
The real rate of return of a portfolio is a better indicator of the growth of the purchasing power of your portfolio. Using the simple method above, if your portfolio earned 6.5% in a year, and the rate of inflation for that same year was 3%, your real rate of return on your portfolio would be about 3.5%, an increase to your purchasing power. But, if the nominal rate of return on your portfolio was 2% in this example, the real rate of return on your portfolio would be about -1.0%, and you would be losing purchasing power. Please see the chart below which illustrates the change in purchasing power of $100,000 over 30 years at 3% inflation using a nominal annual rate of return of 6.5% vs. 2%.  
AFA 30-Year-Purchasing-Power-chart

Now with a better understanding of the staying power of your money over varied periods of inflation, you can consider three options for making it last longer:

  1. Delay taking social security until age 70 and get the benefit increases between age 62, Normal Retirement Age (NRA), and age 70, plus SSI benefits increase with inflation. 

    If you start your benefits early, they will be reduced based on the number of months you receive benefits before you reach your NRA. If you were born from 1943 through 1954, and your NRA is age 66, the reduction of your benefits at age 62 is 25 percent; at age 63, it is about 20 percent; at age 64, it is about 13.3 percent; and at age 65, it is about 6.5 percent. 

    If your NRA is older than 66 (that is, you were born after 1954), you can still start your retirement benefits at 62 but the reduction in your benefit amount will be greater, up to a maximum of 30 percent at age 62 for people born in 1960 and later. 

    If you delay taking your benefits after your NRA, you are rewarded with an 8% increase per year that you wait. So, if an individual with an NRA of age 66 waits until age 70 to take their Social Security Benefit, they are rewarded with a 32% benefit increase over their normal benefit at NRA.

    See the table below for examples.
    Benefit Table
  2. Build a portfolio with a balance of equities vs. bonds based on your individual investment time horizon, risk tolerance, and desire for inflation protection. While stocks and stock-related investments are naturally more volatile than bonds or cash, they can be good as inflation fighters because over the long-term, companies can increase prices as their costs increase with inflation. 
  3. On the bond side of your portfolio, incorporate instruments that have the ability to adjust with inflation. Floating rate notes offer interest rates that adjust and can rise as key interest rates rise.  The rates are reset periodically to reflect changes in key market interest rates. Inflation-linked bonds are usually issued by governments and have interest and principal payments that are adjusted periodically as inflation changes.  
There is no easy one choice for any individual or family and sometimes the right choice may be a combination of options. But to make sure you make the best choice, be sure to discuss with your trusted Atlanta Financial advisor. (2017). U.S. Bureau of Labor Statistics. [online] Available at: [Accessed 8 Nov. 2017]. (2017). Financial Formulas and Calculators. [online] Available at: [Accessed 8 Nov. 2017]. (2017). The United States Social Security Administration. [online] Available at: [Accessed 8 Nov. 2017].

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