Home Insights Asset allocation Don’t underestimate inflation’s knack for dampening retirement spirits

Don’t underestimate inflation’s knack for dampening retirement spirits

December 9, 2024 | 4 min read
Mike Reidy
Director, Client Portfolio Manager
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Inflation may have cooled from its recent multi-decade highs, but for retirees and those nearing retirement, the battle against rising costs is far from over. Age-related price pressures, particularly in healthcare and other essentials, tend to accelerate just as retirees begin to rely more heavily on their savings. For these individuals, preserving purchasing power isn't just a financial goal—it's a necessity.

Although inflation has fallen from its multi-generational highs in recent years, retirees and people approaching retirement should come to terms with the fact that price pressures tend to skew higher as we age. So, retirees are likely better off focusing on achieving higher real returns, that is returns greater than inflation.

Underlying cyclical price pressures and accelerated inflation in healthcare costs weigh especially hard on retirees. Including inflation-protection-related assets in a retirement portfolio is vital to maintaining (real) purchasing power. This approach is equally important for individuals transitioning into the early years of retirement, as they balance the need to grow their savings in real terms while beginning to draw down their retirement funds.

Retirees persistently face higher inflationary pressures

Even before inflation surged into a global concern in 2021, retirees and those nearing retirement had already been losing more purchasing power than other demographic groups. Why? The nature of their major expenses – primarily medical care and prescription drugs. While headline inflation had hovered around 2% (or lower) for decades, the inflation rate for those retiree-essentials had been closer to 4%. For retirees, who allocate a much larger share of their income to spending on goods and services, the disparity has created, and continues to create, a persistent drag on their financial well-being.

How quickly can inflation erode retirees’ purchasing power?

The Rule of 72, a handy mathematical shortcut, offers a simple way to grasp the erosive impact of inflation on retirees' savings. Typically used to estimate how long it takes for an investment to double at a given annual return, this formula can also reveal how inflation eats away at purchasing power. By flipping the perspective, the Rule of 72 can show how many years it takes for inflation to halve the real value of an investor’s retirement savings.

For instance, with a 2% annual inflation rate, purchasing power is cut in half over 36 years; at 4%, however, it happens in just 18 years. For instance, a retiree at age 65 with $1MM saved will see her savings cut in half by age 83 with just 4% annual inflation. That’s without spending anything on housing, food, healthcare or medicines. This stark reality underscores the critical risk that retirees face, particularly during periods of elevated inflation, that is being compounded by the nature of their expenses: longevity risk.

In today’s macro environment, the possibility of outliving their wealth should be a signal to investors to prioritize investment strategies that can cushion the corrosive impact that elevated inflation rates have on retirees. Simply put, including inflation-protection-related assets in a retirement portfolio is vital to maintaining real purchasing power over time.

How to position portfolios for higher inflation

Fixed income is often the cornerstone of capital preservation for investors, but it’s not immune to the pressures of rising or high inflation, evidenced by experiences in 2022 and 2023. During those volatile years, investors who relied solely on fixed income for capital preservation saw their fixed income allocations lose approximately 20% of their savings, cumulatively.

There are some asset classes, however, that have demonstrated a stronger ability to withstand inflationary environments. Investments such as Treasury Inflation-Protected Securities (TIPS), infrastructure, commodities and natural resources, have historically shown the ability to defend against inflation. In 2022, while real assets and TIPS experienced modest declines, their losses were in the low single digits – a stark contrast to the significant downturn in fixed income. For investors looking to protect and preserve capital in retirement, the value of inflation-sensitive assets cannot be overstated.

Protecting retirement savings from inflation helps assuage longevity risk

Although inflation has eased from its 40-year highs, it remains stubbornly above the Federal Reserve's 2% target, steadily eroding the purchasing power of retirement savings. And since retirees face greater price pressures than working individuals, it is essential to safeguard their financial resources against both inflation and longevity risk. Including TIPS and a diversified mix of real assets into a retirement portfolio is a practical strategy for preserving purchasing power and extending the lifespan of investor savings.

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Risk considerations
Investing involves risk, including possible loss of principal. Past Performance does not guarantee future return. All financial investments involve an element of risk. Inflation and other economic cycles and conditions are difficult to predict and there Is no guarantee that any inflation mitigation/protection strategy will be successful.

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