Don't Discount Inflation When Planning for Retirement

Figuring out how much you'll need for retirement requires factoring in many variables: how long you plan to work, your life expectancy, how much you've saved so far, and so forth. But one factor that often gets overlooked and that could play an important role in your retirement spending habits is inflation.

We're all used to the idea that prices tend to rise over time, and while we're working we have the good fortune--hopefully--of getting periodic pay raises, at least to help cover the rising cost of living. But once you are on a fixed income, inflation can become a retirement savings scourge, eating away at the purchasing power of your nest egg. For example, to match the spending power of a retirement account worth $1 million in 1990 would require $1.75 million in today's dollars.

Historically inflation in the U.S. has averaged 3.4% per year since 1914, but in recent years it's been much lower, averaging about 2.4% over the past decade. A recent report by the Federal Reserve Bank of Philadelphia forecasts that inflation will stay around that level for the next decade, but some economists worry that government policies such as the Federal Reserve's quantitative easing and long-term low interest rates could stoke inflation by increasing the money supply too aggressively. That could have a negative effect on retirees and near-retirees whose conservatively invested retirement portfolios would struggle to keep up.

The Bureau of Labor Statistics (BLS), which publishes the Consumer Price Index (CPI) that acts as a barometer of inflation, also publishes what it calls a CPI for the elderly (CPI-E), which it classifies as households owned or rented by someone age 62 or older. (The CPI-E is considered experimental due to its methodological limitations, which are spelled out here.)

BLS reports that from December 1982-December 2011, the CPI-E grew at an annual rate of 3.1% vs. an annual increase of 2.9% for the broader CPI. The agency attributes this difference to the fact that a greater proportion of seniors' spending goes to health-care and housing--two areas that have seen above-average inflation rates over that time--than is true for the general population.

While the overall rate of inflation affects us all, retirees and those thinking about retirement need to be aware of how rising prices in a few key areas will affect their planning. Here are a few of these areas:

Health care: No other area better illustrates how spending habits change as we grow older. In a 2009-10 BLS survey, households with members age 62 and older reported spending 11.3% of annual disposable income (that's income after taxes) on health care, including insurance. The average for all households, including the elderly, was 6.9%.

Medical costs have outpaced overall inflation each of the past 29 years except for 1996, according to the BLS, and have grown 5.1% annually in that time frame. For those planning for retirement--and in particular for those who currently have medical issues or a family history of them--the rising cost of health care should be a major factor in your considerations.

Housing: Senior households spend 44.5% of their disposable income on housing, including utilities, slightly above the 40.2% spent by the general population, according to the survey. Many retirees have homes that are paid off, and for those who don't but who currently pay fixed-rate mortgages, inflation needn't be a concern because payments will not rise. However, property taxes, insurance, home repair costs, and other homeowner expenses likely will. In 2011 property tax collections nationwide rose by only 1.2% due partly to depressed home values, but it was the first time they had risen below the rate of inflation since 1995. Retirees who rent homes also face the prospect of paying more as renting costs increase with inflation.

Energy: Though seniors tend to spend less on transportation than their younger counterparts, it remains a major expense, eating up 14.5% of disposable income vs. 16.5% for the overall population. Energy price volatility has become commonplace, with prices increasing an average of 4.6% per year over the past five years. Even for seniors who don't drive, this can translate into higher costs for travel, public transportation, and consumer goods that have to be shipped.

Food: Senior households spend 12.8% of disposable income on food, about two points below the overall population. But, as with energy, commodity volatility can cause spikes in costs for basic goods. Over the past five years, food prices have climbed 3.3% on average, and this summer's drought across much of the U.S. is expected to drive prices higher, affecting virtually everyone.

Knowing precisely how inflation will affect your spending patterns in retirement may not be possible, but there is a way to ballpark it, especially if you're close to retiring and have a good handle on your expenses.

Start by coming up with an annual breakdown of your household expenses using the categories mentioned above or by creating your own (you may want to add a Miscellaneous category for items not mentioned here, such as clothing and entertainment). Next, calculate each category as a percentage of your total expenses. Then come up with your own projected rate of inflation for each. You can use the historical numbers mentioned above or make your own estimate.

Multiply each category's percentage of your total spending by the projected rate of inflation for that category (remember to use decimals--for example, if 15% of your expenses are for medical care, which you estimate at 5% inflation, that should be expressed as 0.15 x 5). Then add the results together to get a weighted projection of your potential inflation rate in retirement. It won't be a perfect estimate by any means, but it should give you some idea of how inflation fits into your retirement planning picture.

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