Part two of three-part series.
For long-term investors at or near retirement, inflation can be a serious problem.
At this stage, many prudent investors have converted much of their portfolio into fixed income securities to protect the principal from market losses.
Unfortunately, a portfolio heavy in fixed-income securities is hurt most by inflation as eats away the buying power of your portfolio.
Inflation has been held in check in the recent past, but it can still do serious damage to your retirement plans. Aggressive interest rate increases by the Federal Reserve Board held inflation down as the economy was recovering. The recession which began in 2007 kept interest rates down.
This is the second of a three-part series on retirement planning and investing. Links to the other two articles are at the bottom of this article.
However, controlling the economy and inflation is as much art as science and there is no guarantee that inflation won't make a comeback.
Inflation has not been a significant problem in recent years. This may lull some investors to dismiss inflation in their retirement plans.
That would be a big mistake. Even at a modest three-percent rate, which is slightly higher than the past 10-year average, inflation can take a big bite out of your retirement plans.
For example, say you are planning to retire at age 65 on $60,000 per year. If you live for another 20 years, your retirement fund will need to generate $109,000 per year in income by age 85.
Consider another example, a 30-year-old who wants to retire with an annual income of $50,000 in today's dollars. With an inflation rate of three percent over 35 years, it will take $140,700 per year to equal a $50,000 annual salary today.
These examples simply look at the future value projected at three percent inflation. Inflation will not be a constant rate in the future, but these illustrations give you an idea of what to expect. You can find several future value calculators on the Internet.
This is why it is important that your investments stay ahead of the rate of inflation. If we could be sure inflation was going to stay at or below three percent, it would be easier to structure our retirement fund for safety and return.
Almost no one wins during periods of high inflation. Retirees are particularly vulnerable because they may not have enough time to recover from the losses that inflation and a bear market inflict.
There are no easy answers to the inflation problem. A well-diversified portfolio of high-quality investments may be your best line of defense. Very conservative investors may need to move outside of their comfort zone to investments that are more aggressive.
Investment products that pay a fixed rate of return (bonds and bank CDs, for example) are hurt the worst by inflation. Even products that are inflation adjusted are always behind the curve, meaning they lag the inflation rate. Historically, growth stocks or mutual funds have had a better record of staying ahead of inflation.
This is why professional advisors urge people to keep a portion of their post-retirement assets in growth investments.
Retirees can counter the effects of inflation by keeping a percentage of their assets in stocks. Stocks can provide a hedge against inflation over time, while fixed income investments cannot.