Inflation, often referred to as the silent thief, has brought a lot of attention to itself over the last few years. Although it has an impact on our everyday lives, it especially affects retirees living on a fixed income. As you bid farewell to the workforce and embrace the golden years of retirement, concerns about the purchasing power of your savings and investments become more pressing. How will inflation influence your ability to maintain your desired standard of living? Will your investments keep pace with the rising cost of living? Let’s dig into these questions to equip you with the knowledge to safeguard your retirement finances.

Understanding inflation’s impact on retirement

Inflation erodes the purchasing power of money over time, causing prices to rise and the value of currency to decline. While moderate inflation is a sign of a healthy economy, it poses a significant threat to retirees who rely on fixed incomes and savings to meet their expenses. Imagine your retirement nest egg losing its ability to stretch as far as it once did due to rising inflation.

Assessing the risk to your retirement savings

The first step in preparing for inflation’s impact on retirement is to assess the risk to your savings and investments.

Fixed-income assets

Fixed-income assets (such as bonds and certificates of deposit [CDs]) are particularly vulnerable to inflationary pressures since their returns are generally fixed (hence the term “fixed” income). That being said, bonds and CDs have historically exhibited lower volatility. In other words, you know what you are signing up for and what to expect (assuming you hold your bonds until maturity, we’ll get back to that later)

Let’s take an example to illustrate that: Assume you put $1,000,000 of your savings in a 30-year treasury bond that yields 4.20% annually. Unless the US Treasury defaults in that timeframe, you should earn $42,000 every year for the next 30 years (on which you will have to pay federal income tax, if held in a taxable account). (Note that treasury securities are exempt from state and local taxes). However, it is uncertain how far that money will go in 5, 10, 20, or 30 years. If the inflation rate is above the yield, then your real rate of return is negative. Your money is growing at a slower pace than prices, therefore, your purchasing power is eroding.

The Federal Reserve has a “dual mandate” and one of its primary goals is to keep inflation at 2%; however, the high inflation rate over the last few years has shown that it does not always succeed.

Now that we have explained how inflation may impact the real return on your bond, let’s take the example where the coupon payment (the annual interest rate paid on the bond) is not sufficient for you to live on and you need to sell some of your bonds.

There is an inverse relationship between bond prices and yields, meaning that as one goes up, the other goes down (and vice versa). If the market price of a bond increases, it means investors are willing to pay more for it. This usually happens when interest rates in the market decrease or when the bond’s creditworthiness improves. When prices rise, the yield decreases because the fixed coupon payment remains the same relative to the higher price paid. So, the yield adjusts downward to reflect this.

Conversely, if the market price of a bond decreases, it indicates that investors are willing to pay less for it. This often occurs when interest rates in the market rise or when the bond’s creditworthiness deteriorates. When prices fall, the yield increases because the fixed coupon payment remains the same but is now relative to the lower price paid. Thus, the yield adjusts upward to compensate investors for the lower price. This happened in 2022, when 30-year US government bonds lost nearly 40% of their value.

This inverse relationship between bond prices and yields is crucial for investors to consider when making investment decisions, as changes in interest rates and market conditions can impact the value of their bond holdings.

Stocks

Stocks, on the other hand, have historically provided a hedge against inflation, offering growth potential that outpaces the rate of inflation over the long term. One reason is that companies can adjust their prices upward in inflationary environments, which means that their earnings and cash flows may also increase, leading to higher stock prices. Inflation may also drive up the value of tangible assets owned by companies, such as real estate, machinery, and inventory. These assets can appreciate in value over time, contributing to the overall increase in the company’s market capitalization and stock price.

The drawback of stocks’ higher long-term performance is higher volatility and uncertainty. Unlike fixed-income securities, you don’t know what your returns will be or how your portfolio value might fluctuate.

Let’s take an example: Assume you put today $1,000,000 in an ETF that tracks the S&P 500. If it grows 4.20% in the first year, just like the treasury bond in our previous example, then it will return the same amount: $42,000, minus any tax due. Had it returned 8% and you withdrew those $42,000 for living expenses, your portfolio would now be worth $1,038,000. Even though it might sound better than the previous fixed income portfolio example, note that your stock portfolio could also go the other way and lead to a negative 8%. In that case, your portfolio would be worth $1,000,000 – $80,000 – $42,000 (the distribution you need for your living expenses) = $878,000. For your portfolio to be back at $1,000,000 the following year (distribution taken out), it would need to yield 18.67%.

The S&P 500 (an index tracking some of the largest U.S. stocks) has returned 10.14% annually over the last 30 years (through 2023), while inflation (as measured by CPI year-over-year) has averaged 2.5% over that same time period.* Historically, the stock market has outpaced inflation, but retirees who rely on their portfolio for living expenses must be aware of its volatility. In some years, the market may be down and if you are retired, you will need to tap into your portfolio regardless of its performance.

As a rule of thumb, the closer you get to retirement, the less volatility (uncertainty) you can handle, hence the general recommendation to reduce your stock allocation and increase your fixed income share, even if the threat of inflation remains.

Strategies to mitigate the effects of inflation

· Diversification: Spread your investments across a mix of asset classes, including stocks, bonds, real estate, and commodities, to reduce the risk associated with inflation.

· Inflation-Protected Securities: Consider allocating a portion of your portfolio to Treasury Inflation-Protected Securities (TIPS), which adjust their principal value in line with changes in the Consumer Price Index (CPI), providing a built-in inflation hedge. Investors do need to be careful with TIPS though, as their interest rate risk can be very high, and they can lose a lot of value in inflationary environments if rates move up.

· Dividend-Paying Stocks: Focus on dividend-paying stocks, as companies that consistently grow their dividends tend to offer a reliable source of income that can keep pace with inflation (even though they may experience some volatility).

· Real Assets: Invest in real assets such as real estate and infrastructure, which have intrinsic value and tend to appreciate over time, serving as a hedge against inflation. Again, careful analysis is required as highly levered real assets (like real estate) can lose value in inflationary environments if rates rise.

· Alternative investment: at MFA, we believe diversification would not be complete without some alternative investments. For years, we have recommended private alternative investments that we have carefully selected.

 

Monitoring and adjusting your retirement plan

As you transition into retirement, it’s essential to regularly monitor and adjust your financial plan to account for changing market conditions and inflationary pressures. Stay informed about economic trends, interest rate movements, and inflation forecasts to make informed decisions about your investment strategy and withdrawal rate.

Conclusion

While the specter of inflation may loom large on the horizon, proactive planning and prudent investment choices can help mitigate its impact on your ability to afford retirement. By diversifying your portfolio and staying vigilant about monitoring your finances, you can enhance the resilience of your retirement nest egg and enjoy the peace of mind that comes with knowing your financial future is secure, come what may. We recommend working with a financial advisor. If you already have one you trust, stick with it. If you do not or you would like a second opinion, feel free to schedule a call with one of our advisors at no cost.

*Source: Bloomberg

 

Morling Financial Advisors, LLC (“MFA”) is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about MFA’s investment advisory services can be found in its Form ADV Part 2 and/or Form CRS, which is available upon request.

The opinions expressed are those of MFA. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Forward-looking statements cannot be guaranteed. Material presented has been derived from sources considered to be reliable, but accuracy and completeness cannot be guaranteed. The investment strategy or strategies discussed may not be suitable for all investors. Be sure to consult with a tax professional before implementing any investment strategy. Investors must make their own decisions based on their specific investment objectives and financial circumstances.

The information contained herein should not be considered a recommendation to purchase or sell any particular security or sector.