How Retirees Should Think About Inflation in 2021

Christine Benz: Hi, I'm Christine Benz for Morningstar. Low inflation has provided an invisible helping hand to retirees over the past decade. But should retirees be on their guard for higher prices? Joining me to discuss the role of inflation in retirement planning is David Blanchett. He is head of retirement research for Morningstar. David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: David, let's start with a broad question. How does inflation affect retirees, and why is it potentially even more worrisome for retirees than it is for the broad population?

Blanchett: Inflation is an interesting consideration. If you actually look at retiree fears, inflation risk is actually up there with like healthcare and outliving their resources. And to some extent, I think inflation risk is somewhat overblown for retirees. And I'll explain why. Retirees--almost every retiree out there--gets Social Security, and that's indexed to inflation. And most retiree spending actually tends to decline with inflation over time. But the one kind of great unknown is healthcare expenses, and those are the one piece of spending that tend to rise over time. There's actually different definitions of inflation. There's the CPI-U, the CPI-W, the CPI-E. And those are built using different what are called consumption baskets--so what does the average person spend money on? And the older version of inflation, the CPI-E, it's tended to rise by more than base inflation because of healthcare expenses. So, I don't really worry as much about the other pieces of inflation as I do healthcare and thinking about the impact possible of inflation for retirees.

Benz: We want to touch on another aspect of that CPI calculation, the role of housing. If you look at the CPI for the elderly as well as the CPI-U, housing is a big chunk of it, like close to 50% for the CPI-E. But some retirees might say, "Well, I own my home, so I am not really subject to inflation in that category." How should retirees think about that?

Blanchett: It's really interesting. For those of you out there that love to look at data, you can go to the Bureau of Labor Statistics website. You can actually get like very detailed information on retiree expenditures. And it's totally true that by age 90 a lot of folks own their home. And people are often like, "Well, why do these older people that own their homes spend more on housing?" It's because they're not mowing their yards anymore. And so, what happens actually, it's an interesting fact where the older that you are, as housing, the less you're going to be spending on mortgage payments, the more you're going to be spending on things like maintenance that you just can't do yourself. Now, to your point, though, housing to some extent does become less of an issue if you own your home, but it's all the things that are involved in operating a house that older Americans become less and less likely to be able to do themselves.

Benz: And not to get too in the weeds, but how does it handle the fact that someone might be living in some sort of an assisted living facility where costs can run really high and be a big portion or maybe all of someone's expenses?

Blanchett: Well, in that instance, you could actually have the double whammy--you could be paying for a house and being paid for healthcare. So, like that would be usually under healthcare expenses. And the one thing that--I don't really love a lot of the research that talks about, "Healthcare is going to cost you like $400,000. You got to save," because that's actually not the unknown expenses, right? Like the shock that people incur when it comes to healthcare is really that nursing-home-care stay. And I mean, to be honest, that isn't a big expenditure for most households. The problem is, it is significant for some, and it's just so hard to plan for. So, housing as like normal housing isn't necessarily a big concern. The thing that I really can't answer at all is: How do you plan for that kind of end-of-life nursing-home-care stay? And the answer could be, "Well, David, buy a long-term-care insurance." Well, a lot of folks that want it can't get it. It's very expensive. And so, I just don't know what the best answer to that question is.

Benz: Yeah, and that's kind of a detour from our main topic on inflation. Getting back to inflation, if someone is thinking about their retirement plan, perhaps they haven't yet embarked on retirement and they're trying to figure out. "Well, what is a reasonable inflation assumption that I should incorporate into my plan?" How should retirees think about that, because inflation has been really low over the past decade. I guess the question is, Will that carry forward? And we really don't know.

Blanchett: Right. And so, historically in the U.S., the average inflation rate has been like 3%. Now, to be fair, that includes like the '80s when interest rates were like 12% to 15%. And so, right now, a great estimate of inflation would be like the Cleveland Federal Reserve has an estimate to say, "Hey, what do we expect inflation to be for the next eight, 10 years?" And it's usually 2%-ish or less. One really important kind of thing to be aware of, though, and I have researched this and others have as well, is that retiree spending does not tend to increase by inflation every year. So, I think it's important to incorporate potentially an inflation estimate in a projection. The issue is that Social Security benefits are already indexed to inflation. Those will rise with inflation every year. And for a lot of retirees, that's about the only increase that they need. And so, one concern that I have is that if you assume that retiree spending increases every year by inflation, say 2% a year, that's actually not going to capture what the average retiree does in terms of increases in spending throughout retirement.

Benz: Switching over to the portfolio, if I'm building a retirement portfolio and I want to ensure that it helps defend against inflation over time, what are the key categories that I want to think about incorporating into that portfolio?

Blanchett: It's not an investment, but Social Security retirement benefits would be an excellent hedge because they're linked to inflation, and they're a very good deal in terms of the cost of the "guaranteed income." The other most obvious asset is any kind of government bond that's explicitly linked to inflation. These are called TIPS. The problem is is that the yields on these are pretty atrocious right now. They're negative. There's like a negative 0.6%-ish return. And so, I think that's one possibility. Others are what people would call real assets, like real estate or possibly commodities. The problem is is that while these can be a decent hedge for inflation, they're not great. So, once you kind of move away from investments that are directly linked to inflation, like Social Security or TIPS, it becomes a lot more loose relationship.

Benz: Equities though potentially at least outearn inflation ...

Blanchett: Well, so, yeah, that's a great point. Equities aren't really a great inflation hedge. But to your point, equities have done a great job beating inflation historically. So, I wouldn't necessarily describe equities as an inflation hedge, but I would describe them as a way to say, "Hey, equities have done a fantastic job historically of beating inflation when inflation is higher." That would be one way to, say, "Hey, I'm worried about inflation." Equities would be one way to say, "I'm going to minimize the risk of inflation on a portfolio."

Benz: David, super helpful discussion. Thank you so much for being here.

Blanchett: Sure thing.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.