How to Protect Your Retirement From Nagging Inflation

The Social Security cost of living adjustment for 2024, expected to be announced Thursday, is forecast to be 3.2 percent, far below the 8.7 percent increase older Americans received this year. The smaller increase would reflect the cooling of consumer prices, but inflation is an ever-present risk that should be a consideration in your retirement plan.

Although Social Security is adjusted annually for inflation, it will cover only part of your spending in retirement. Over a retirement that is several decades long, inflation can erode the buying power of your other assets, forcing a quicker spend-down and threatening your standard of living. For example, a retirement portfolio valued today at $250,000 would buy the same amount of goods as $137,000 in 2000.

“Inflation really is another form of longevity risk,” said Joel Dickson, global head of advice methodology at Vanguard. “If your portfolio going into retirement is projected to be able to satisfy your spending needs for 30 years, an inflation shock might mean that it can only do that for 27 years, and those last three years aren’t being covered.”

The risk you’ll face from inflation depends on your circumstances. Social Security replaces a higher share of pre-retirement income for middle- and lower-income retirees than it does for affluent people, and that means a greater share of their retirement income will be protected by COLAs. And benefits cover a much larger share of living expenses in low-cost parts of the country.

Your exposure to major expenses also can make a difference.

Older households spend more on health care than younger people do, and they spend slightly less on food and transportation, according to research by J.P. Morgan Asset Management. Housing is the largest category of expense for all households. And for older people, whether you own your home or rent is an important factor in financial security, notes Sharon Carson, retirement strategist at the company.

“Homeowners might be dealing with rising property taxes and maintenance costs, but renters are so much more exposed — and rising rents have been a huge part of the inflation story lately,” she said.

Portfolio strategies are available that can help mitigate inflation risk. The timing of your Social Security claim also matters — and you may want to consider other income products, such as annuities and inflation-adjusted bonds.

Winning the race with equities

Holding equities in your portfolio in retirement offers some protection, because they have proved to outpace inflation over the long haul. Vanguard advises clients to maintain a balanced portfolio (50 percent stocks, 50 percent bonds) in the early years of retirement. “It depends on the client’s risk tolerance, but having equities in the portfolio helps you maintain the ability to spend from your portfolio,” Mr. Dickson said.

But stocks are not specifically a hedge against inflation. “There will be some years where stocks are down and inflation is high, so they are wildly imperfect as an inflation hedge,” said Bob French, director of investment analysis at Retirement Researcher, a retirement-planning education firm.

The rate at which you expect to draw down your portfolio is equally critical when thinking about inflation risk.

Researchers have been debating for years what constitutes a “safe withdrawal rate” — that is, the amount you can tap annually, with adjustments for inflation, without exhausting your savings before the end of life.

The old rule of thumb was 4 percent, but some experts now think that number should be somewhat lower, with much depending on two crucial factors: real (after inflation) market return, and whether you encounter tough market conditions in the initial years of your retirement. The latter is known as “sequence-of-return risk” and will reduce the longevity of your portfolio.

William Bernstein, an investment adviser and author of “The Four Pillars of Investing,” relies on a relatively conservative assumption that the market’s real return will be no more than 4.5 percent in the years ahead — and that many will encounter sequence-of-return risk. With that in mind, he concludes that a burn rate of 3 percent or less can succeed for portfolios that continue to hold some level of equities — perhaps 20 to 30 percent.

“If your rates of return are lower during your first 10 years of retirement, you’ll run out of money a lot sooner than 30 years,” he said. “So that’s why I like to say that 3 percent is probably safe.”

If your burn rate is lower than that, he adds, your asset allocation doesn’t matter much — especially if you can meet much of your living expenses with an optimized Social Security income stream or a defined benefit pension. Your portfolio will survive difficult markets and bouts of inflation with no difficulty — and the assets will be available for discretionary spending, charitable giving or your heirs.

Social Security: All in the timing

Social Security’s automatic COLA makes it the only true inflation hedge available to retirees — and one of the best ways to maximize that protection is to delay claiming your benefits to increase monthly income.

You can claim retirement benefits as early as 62, but your annual benefit will be higher for every year you wait until 70. The monthly benefit you receive hinges on what the government defines as your full retirement age — the point when you qualify to receive 100 percent of the benefit you have earned. Currently, the full retirement age is 66 and a few months for most people. (For those born in 1960 or later, it’s 67.) If you claim after full retirement, you’ll receive credits for delayed filing; claim earlier and there will be reductions. Claiming at the full age is worth 33 percent more in monthly income than a claim at 62, and a claim at age 70 is worth 76 percent more.

COLAs calculated against a higher benefit will translate into larger dollar increases — and those, too, will compound over time. “The very first, overriding move that you make is to delay Social Security until age 70,” Mr. Bernstein said. “Unless you and your spouse have short life expectancies, any other strategy is subservient to that.”

Social Security offers the best route to boost real income, he argues — especially because the actuarial assumptions driving the current formula of delayed retirement credits and early claiming reductions have become outdated over the years in ways that favor delayed claiming. The formula was designed in the mid-1950s; since then, interest rates have fallen substantially and life expectancy has risen. A study by the Center for Retirement Research at Boston College found that the highest earners, who tend to outlive actuarial averages, reap the highest extra benefits; low-income filers, who tend to claim earlier, are hurt most by the outdated formula.

Working longer, even part time, can help you meet living expenses while you delay claiming. One group of researchers found that delaying retirement for three to six months has an impact on your standard of living equivalent to bumping your annual retirement savings rate by 1 percent for 30 years.

If working longer isn’t in the cards for you, Mr. Bernstein urges using savings to delay your claim. “The default should be to draw down everything you’ve got to make it to age 70 — your 401(k), your I.R.A. and your taxable savings.”

Pensions and annuities

Private-sector defined benefit plans, or pensions, generally do not come with built-in COLAs, so the real value of their income streams fall over time. Most state and local government pensions do have COLAs, although the formulas vary considerably.

Commercial annuities can offer generous payout rates. For example, a fixed index annuity, which is a bond-like product with returns tied to market performance — currently offers a payout rate of about 9 percent, according to DPL Financial Partners, which operates a commission-free annuity marketplace.

But no annuity products offer COLA riders tied to the Consumer Price Index. Fixed index annuities, and some others, can be bought with guarantees of annual income increases, said David Lau, DPL’s chief executive. “It might be a simple COLA of 2 or 3 percent that increases automatically over time,” he said. “It’s not a perfect hedge against inflation, but it does increase your income.” These riders come with a cost — they start with a considerably lower payout rate.

How about inflation-protected bonds?

Treasury inflation-protected securities, known as TIPS, offer a seductive-sounding promise: The bond’s principal value rises (or falls) to keep pace with inflation. TIPS are risk-free if you hold them to maturity, but the road to that end point can be bumpy and the price you’ll pay for the inflation guarantee varies.

One solution is to put some portion of your portfolio into a TIPS “ladder” — that is, creating a staggered portfolio of bonds that mature at regular intervals; as the bonds mature, the proceeds can be spent or used to buy new TIPS with longer maturity dates.

Mr. Bernstein notes that the current real yield on TIPS is attractive. “It’s about 2.5 percent over the entire yield curve — if you’re 70 years old, a 30-year ladder would be safe enough for most people.”

Financial planners can construct these ladders, but building and maintaining them can be a complex chore, Mr. Bernstein acknowledged. “For the average person, it’s probably not appropriate,” he said. More practical options for do-it-yourselfers, he said, include low-cost short-term bond funds or a traditional open-end or ETF TIPS fund. (Examples include the Schwab US TIPS ETF and the Vanguard Inflation-Protected Securities Fund.)

Another simple option is the I bond — a type of U.S. Treasury that pays both a fixed rate and another linked to inflation. One downside: There’s a purchase limit of $10,000 per year for an individual, or $15,000 if you buy one using a federal tax refund.

Tapping home equity

Most older Americans are homeowners, and home equity is a source of wealth that can be tapped if inflation takes a substantial bite out of other assets. A Vanguard study found that among people who retire and relocate, about 60 percent sell their homes and move to a less expensive location — and typically unlock about $100,000 of equity.

If moving isn’t in the cards for you, reverse mortgages offer another way to make use of home equity, although they have not been especially popular with retirees because of their complexity and high fees.

“Housing equity might be an asset that you don’t normally want to tap, but it might be useful for something like a long-term care expense or if you’re finding that inflation is eating into your portfolio substantially,” Mr. Dickson said.