Inflation is the gradual rise in the prices of goods and services over time. When inflation increases, each dollar you hold buys a little less than it did before. A modest level of inflation is a normal part of a healthy economy, but even moderate price increases compound year after year. Over a long retirement, inflation can significantly reduce the purchasing power of money that is not growing.
The impact is easiest to see with cash savings. If your savings account pays less interest than the rate of inflation, your money is effectively losing value even though the balance appears to grow. This is why financial planners talk about real returns, meaning the return you earn after accounting for inflation. A strong plan aims to grow your money faster than prices rise.
Keep cash, but keep it working
An emergency fund held in cash is still essential, because it protects you from unexpected expenses without forcing you to sell investments at a bad time. The key is to keep that money in a high-yield savings account, money market account or short-term certificates of deposit that pay a competitive rate. Holding more cash than you need for emergencies and near-term goals, however, can leave you exposed to inflation over the long run.
For long-term goals, investing in a diversified mix of assets is one of the most effective ways to outpace inflation. Historically, stocks have provided returns that exceed inflation over long periods, because businesses can raise prices and grow earnings as the economy expands. Real estate and real estate investment trusts can also benefit from rising rents and property values.
The greatest risk to long-term savings is not always a market crash. Sometimes it is the slow, steady loss of purchasing power.
Inflation-aware investing and borrowing
Treasury Inflation-Protected Securities, known as TIPS, are U.S. government bonds whose principal adjusts with inflation, which can help protect the fixed-income portion of a portfolio. Series I savings bonds offer a similar inflation-linked return for individual savers, subject to annual purchase limits. These tools can add stability to a plan without sacrificing purchasing power.
Inflation affects debt as well. Fixed-rate loans, such as a fixed-rate mortgage, become relatively easier to repay over time because your payment stays the same while wages and prices generally rise. Variable-rate debt, on the other hand, can become more expensive when inflation prompts interest rate increases, so paying down variable balances is often a smart priority during inflationary periods.
Finally, review your budget and your long-term plan regularly. Rising costs for groceries, energy and insurance may require adjustments to your spending and savings targets. Increasing your retirement contributions as your income rises and planning for inflation in your retirement income projections will help ensure your future lifestyle stays on track.
The advisors at Future Finance Zone help clients across the Denver metro area build inflation-aware savings and investment plans. Contact us for a free financial review.