Inflation’s Impact on Retirement Savings

How does inflation affect the rate at which you save for retirement? How does it reduce the value of your existing savings? How can you prepare for the future and respond optimally?

How Inflation Impacts Savings

Inflation’s impact on future costs is not significantly different from its current impact. The main difference comes from something we often use to our advantage, compounding rates. Much like how a high investment return every year can lead to massive gains over a long period of time, so can high inflation lead to increasingly higher costs.

While high inflation is unlikely to surpass investment returns, it does diminish the impact of the gains you get from those returns. Inflation is normally factored into retirement planning, but unexpected or unaccounted-for inflation over a long period of time can start to harm those plans. This can lead to certain retirements not being as successful as originally planned.

Need More, Have Less

Inflation inherently increases your cost of living. This makes it harder for most households to save for their future, as those dollars are needed to meet present-day expenses. This can hit lower-income households even harder, as there is less excess to cut away. High-income households may have some leeway to cut discretionary spending in order to meet rising cost of living expenses.

Inflation also decreases the value of the dollars you have already saved. While the returns of invested dollars will usually outpace inflation in the long run, the extent to which they outpace inflation is reduced. This means you need to save even more to counteract this effect, which, as previously mentioned, is more difficult in times of inflation. Many investments, on the other hand, naturally grow with inflation, and this helps reduce the negative impact of inflation on your portfolio.

Using a future value equation (FV = PV * (1 + r)^n), you can calculate how different rates of inflation can impact your savings over a certain number of years. For example, an item costing $1 today with 3% inflation over 30 years will cost $2.43. If you change that rate to 4% inflation, it rises to $3.24 in the same time period. With just this simple calculation, it is easy to see how inflation over the course of your life can have an impact on the money you have saved.

To compensate for inflation, you will need to save 4/3 more in the 4% scenario to get the value you would have received in the 3% scenario.

Conclusion

Inflation has incredibly broad and deep effects on the economy as a whole and on those within it. Knowing how it affects the world around us allows us to be better prepared for it. When trying to combat inflation’s negative effects on our lives, we should not just focus on its immediate effects, but also on the future.

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