What Is Inflation and How Does It Affect Retirement Income?

Inflation, or an increase in prices from one year to the next, is inevitable and can decrease purchasing power over time and impact savings and investment returns. The rate of inflation is significant as it represents the rate at which the real value, or the adjusted value after inflation, of an investment changes spending power over time. In layman’s terms, inflation means that goods and services will cost you more in the future because prices increase with time.

According to the U.S. Price Index, inflation has averaged 3 percent a year and needs to be accounted for when considering annual living expenses in the future. If you are saving for retirement, you need to factor inflation into your overall investment and savings plan to properly save for your projected retirement spending behaviors.

How Inflation Affects You

A good example of inflation is the increase in the cost of a loaf of bread over time:

In January 1988, the U.S. Department of Labor Bureau of Statistics notes that the cost of a loaf of white bread cost approximately 59¢. In January of 2013, that same loaf of bread cost $1.42. So, in a 25-year period, the cost of bread increased by 83¢ or rose by 140 percent.

The substantial increase in cost in bread is a little misleading, which is why the Bureau of Labor Statistics gathers pricing data on thousands of items monthly from many geographical locations across the U.S.

By taking price samples across many regions, a more accurate sampling of cost items can be figured to assess the actual cost of inflation for both historical and projection purposes. This sampling is known as the Consumer Price Index (CPI), sometimes referred to as the cost-of-living index.

Causes of Inflation

Inflation is a bit tricky as there is no universally agreed upon reason as to the cause of price escalation. Typically, with time and society growth, there tends to be price increases. Here are a few hypotheses about what causes inflation:

• Demand-Pull Inflation – When there is an increase in demand for goods and services, prices increase. Basically, if demand is growing faster than supply, prices will escalate. This typically occurs in economies that experience rapid growth for a myriad of reasons.

• Cost-Plus Inflation – If the cost of production goes up, inflation can be a result. Companies need to increase prices to maintain profit margins. These increased costs can include wages, taxes or costs of natural resources or imports.

• Monetary Inflation – When there is an oversupply of money in the economy, prices tend to go up as, once again, as prices are determined by supply and demand.

Consider Inflation When Investing

Inflation is vital for investors as it tells you exactly how much of a return your investments need to make for you to maintain your standard of living. Since the main goal of investing is to make money for your future, you need to consider the cost of goods in the future. Check out the CPI inflation calculator to help you forecast inflation with your retirement saving and investing goals.

Inflation is ultimately about money growth, so with this idea in mind, investors should try to buy investment products with returns that are equal to or greater than inflation. For example, if ABC stock returned 4 percent and inflation was 5 percent, then the real return on investment would be negative. You can help protect your purchasing power and investment returns by investing in a number of inflation-protected securities such as inflation-indexed bonds or Treasury inflation-protected securities (TIPS). These types of investments move with inflation, so they are immune to inflation risk.

An expert financial advisor can help you develop an investment portfolio and long-term investment plan that works for your unique situation.