The Power of Compounding
When you are saving for retirement you hope that your investments will grow over time. The sooner you begin saving the more time you will be able to take advantage of the power of compound interest.
This is because you are potentially able to achieve growth on your growth. Not just growth on your initial investment. This may seem hard to conceptualize, but there is an easy way to see how it works.
It is called the rule of 72 and it shows you how long it will take for an investment to double. To perform the calculation you divide the number 72 by the rate at which the investment will increase in value.
The resulting number is how many years it will take for a hypothetical investment to double. The graphic below shows some hypothetical examples to illustrate how the rate of return affects the time of doubling.
The Power of Negative Compounding
The power of compound interest can provide a large tailwind for someone who has many years of saving ahead of them. Unfortunately, for people who are in retirement and are utilizing their personal savings to fund their living expenses, they can potentially have compound interest working against them.
This is because of the impact inflation has on your purchasing power over time. The average annual rate of inflation since 1914 has been approximately 3%, according to the U.S. Department of Labor. This means at 3% annual inflation, something that costs $100 today would cost $200 in 24 years. This potential of negative compounding could have serious implications for a retirement that could last for 30+ years.
Addressing Inflation In Retirement
We can go back to the equation I’ve discussed in prior posts to see what can be done to combat inflation.
Income – Expenses = The Gap
Inflation’s Impact on Your Expenses
We know your expenses will increase in retirement, but everyone is impacted by inflation differently. This is because all goods and services do not increase uniformly.
Different sectors have different inflation rates. Also what you spend money on can shift over time and certain expenses can become a larger percentage of your spending in retirement. Healthcare costs, for example, are expected to increase faster than the average inflation rate.
It is also something that could become a larger proportion of your spending in retirement as you age. With this in mind, it could be prudent to separately account for your healthcare expenses in your retirement spending plan.
Inflation’s Impact on Your Retirement Income
The income you receive in retirement can play an important role in funding your living expenses. This role could be diminished based on the source of the income stream. Not all pensions or annuities are adjusted for inflation. This means they can lose their purchasing power over time.
Social Security, on the other hand, has an annual cost of living adjustment, COLA. This means it increases with inflation. This inflation adjustment is regardless of the size of your monthly Social Security benefit.
If you were able to delay claiming your Social Security, the increased monthly benefit you receive will be adjusted for inflation. This larger monthly benefit could mean a greater portion of your retirement income is less sensitive to a loss of purchasing power.
Inflation’s Impact on Your Retirement Income Gap
If your retirement income does not cover all your expenses you will need to fill this income gap with your personal savings. This income gap may become larger over time if your retirement income does not increase with inflation.
This widening income may require you to rely more on your personal savings later in retirement. With this being the case, it is important to invest in a way that allows you to maintain your purchasing power.
You may have investments that aren’t decreasing in value in nominal terms but are losing their purchasing power when accounting for inflation. With this in mind, you could look at your portfolio’s real rate of return, meaning adjusted for inflation.
If your current allocation is not keeping pace with inflation you may consider investing a portion of your portfolio in things that can potentially generate returns above inflation.
These investments would be earmarked for the long term. They are meant to fund your future expenses and could experience short-term market volatility.
Inflation is yet another risk you may face in retirement, though its effects may not be felt for many years. With smart planning and prudent investing, there are ways to attempt to mitigate its effects on your purchasing power.
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