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Safeguarding Your Retirement Income Amid Inflation

Prior to 2021, Americans had not endured noteworthy consumer price inflation since before the 2007-2008 financial crisis. During 2021 and 2022 consumer prices surged. Trying to tame inflation, the Federal Reserve lifted interest rates higher than they had been since the early 2000s. While the rate of inflation has diminished, it has remained above the Fed’s target of 2%. Even though the rate has fallen, the prices that have already risen are not necessarily falling. This post discusses inflation with respect to retirement income, and how the Retirement Income Solution, or Spenddown module of the GuidedChoice Advisory Service can help.

While the rate of inflation has diminished, it has remained above the Fed’s target of 2%. Even though the rate has fallen, the prices that have already risen are not necessarily falling.

Understanding Inflation in the Context of Retirement

When the amount of money available to spend on goods and services grows rapidly, if the supply does not also change to meet the demand, then prices go up, sometimes rapidly. Thus, we measure inflation rates as the year-over-year change in prices. Different items’ prices change at different rates, so how much you feel the pinch of inflation depends on how much the items you purchase increase.

As a result of inflation, people adjust their spending. People might opt for public transit instead of driving, or not to take trips they were planning. They might also change their diet. People might also take on an additional job to supplement their income or even move if they can no longer afford to live at their present address.

All these responses can increase people’s stress and diminish their health and wellbeing. An even worse response would be to decrease one’s healthcare spending, which would directly diminish a person’s health.

Retirees, who typically live on fixed incomes, may not have the ability to look for work. Even if they do, they probably were not planning on it. When you live on a fixed income, it helps if the expenses in your life this year are much the same as they were last year. When prices rise rapidly, it helps if you have a cushion to absorb the higher spending and it also helps if your income adjusts with the cost of living.

The Direct Impact of Inflation on Retirement Planning

Thus, retiring securely means not only being able to afford the life you want in retirement as if prices would never rise again, but also to be able to adjust to price increases as they (inevitably) occur.

Fortunately, most American seniors have access to Medicare and to Social Security Retirement Income. Medicare makes staying healthy more affordable than if people had to pay for all their medication and healthcare out of pocket. Social Security Retirement Benefits adjust for changes in the cost of living. If you visit ssa.gov, you can find the past schedule of cost-of-living adjustments (COLAs) that have been applied to retirement benefits over time. What this means is, if your retirement benefit this year from Social Security is $40,000, and over the next 10 years the cumulative consumer price inflation rate is 30%, then 10 years from now your Social Security retirement benefit will probably be around $52,000, or 30% higher than it is now. In effect, Social Security retirement benefits are equivalent to an inflation-indexed annuity.

While it is convenient that Social Security acts as an inflation-indexed annuity, many Americans plan to spend more in retirement than what Social Security provides. They need to have other sources of wealth, including financial assets and, possibly, other sources of income.

People in retirement or nearing retirement could purchase an annuity, but if you do so, you need to pay attention to whether the annuity payments increase over time. It might be easier to find annuities whose payments increase by a scheduled rate, such as 2% or 3%, than to find one that is specifically indexed to the consumer price index, or CPI.

Another thing people in retirement should do is keep their financial assets invested appropriately. What is appropriate depends on their household wealth and sources of income. Retirees understandably wish to avoid market volatility and thus allocate less to stocks than they did during their working years. But they should still hold some allocation to stocks. To the extent their spending is supported by Social Security and other forms of income, they can afford to take equity risk in their portfolio. To the extent they are subject to longevity risk, it makes sense to do so.

GuidedChoice’s Spenddown: Model Your Inflation-Adjusted Retirement Income and Plan Your Retirement Spending

GuidedChoice’s Spenddown tool is based on award-winning financial thought leadership. Spenddown is a whole household wealth planning tool for retirees and near-retirees. Spenddown helps you model your spending in retirement after taxes and taking inflation into account. Once Spenddown knows the values of all your pools of assets and income, Spenddown invites you to project how much you wish to spend. Don’t worry, if you try a spending level your wealth cannot support, Spenddown will let you know. But many people are pleasantly surprised by how much Spenddown tells them than can afford to spend. Don’t know how much you need to spend? Spenddown provides a helpful budgeting template.
Simple formulas and other calculators are flawed

In 1994 William Bengen wrote about the “4% rule” so people could calculate the maximum they could spend in retirement. The idea was you calculate 4% of your wealth at retirement and you could withdraw that amount in constant dollars for the rest of your life. An obvious flaw with this method is that it is static: it does not allow you to vary your withdrawal amount except for inflation. Further, it results from assumptions about interest rates and investment returns we would find optimistic today.

Instead of planning based on an assumption about an average scenario, you would be much better off to plan based on multiple scenarios, one that updates mortality expectations as you age.

Financial time travel: Simulating plausible financial futures

How does Spenddown know how much you can securely spend? Because it generates decades of simulated future paths of interest rates, inflation rates, and investment returns, each stemming from the current environment. It evaluates spending levels based on your needs and wants throughout your household’s expected lifespan and recommends a spending level this year that is expected to be sustainable for your household.

We have all done scenario planning, regardless of whether we realized that was what we were doing at the time. Whenever we considered a decision and asked, “what’s the worst that can happen?” we were scenario planning. More complete scenario planning often includes thinking about a possible worst-case scenario, a best-case scenario, and a most likely scenario.

Even better than planning with only a handful of scenarios is planning based on Monte Carlo simulation. Think of Monte Carlo simulation as supercharged scenario planning. With Monte Carlo simulation, instead of only a handful of scenarios, we obtain thousands. (If you are a sci-fi fan, you might prefer to think of Monte Carlo simulation as a multiverse of future paths for changes in interest rates, investment returns, and inflation rates, stemming from current conditions.)

Using thousands of scenarios instead of a single average is especially important when planning over several years based on investment return scenarios, because the longer the time horizon, the more skewed the range of outcomes.

Best way to plan: Obtain an answer now, then check again later

Chances are you will not spend the same amount in Year 20 of your retirement as you did in Year 1. In current dollars, many retirees spend more in the first few years of retirement, understandably because they are better able to enjoy travel and other activities more than they might when they get older. Some might wish to leave a specific bequest amount or implement a giving plan. Even for retirees who wish to spend the same amount each year, fluctuations in interest rates and inflation make this an unlikely outcome.

Spenddown does not pretend to be the final word on spending for the rest of your life. Rather, it is a tool that gives you the best answer this year, subject to you checking again next year, etcetera.

Spenddown’s comprehensive features

Spenddown considers all the information you provide about your household situation, including

  • how much you need to spend,
  • how much you want to spend,
  • the state where you file taxes,
  • your age and your spouse’s age,
  • all your assets and sources of income, and
  • how much Social Security income you expect to receive
  • whether you wish to leave a bequest, and if so, how much

Spenddown then informs you, based on the inputs, how much you can securely expect to spend in retirement, based on today’s information. Spenddown tells you which assets to draw from this year, taking taxes into account, and suggests changes to your asset allocations, if necessary. Finally, Spenddown emails you a pdf of your advice.

Considering an annuity? Go ahead

Spenddown includes a tool to help you model purchasing an annuity, to decide whether doing so would make sense. Just enter a few details about how much you wish to spend and when you wish it to begin, to see an estimate of how much steady income you can purchase by spending that amount.

Now you take the wheel

Your situation is unique, so you need a unique plan. Instead of steering you to a precalculated answer, Spenddown lets you drive. Next, you get to consider your options. You may model whether your outcome might change, and if so, by how much, if:

  • You live to 100
  • You pass quickly
  • You work part-time
  • You purchase an annuity
  • You budget for spending more over the next few years, such as for travel

You may also model the same scenarios for your spouse and a combination of scenarios at the same time.

Once you have the result you like most, Spenddown creates a pdf guide that spells out all the steps you need to follow to implement your plan. Print and/or email it to yourself for future reference.

Unlike the 4% rule, this advice is perishable. Just as a good GPS device refreshes its advice along the way, Spenddown will refresh your advice next year and/or when your household situation changes.

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