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The Impact of Inflation on Retirement: A Closer Look Thumbnail

The Impact of Inflation on Retirement: A Closer Look

In this episode of Friends Talk Financial Planning  Bridget and I discuss the impact of inflation on retirement. We explore different approaches to factoring in inflation, with Bridget taking a more conservative approach. We also discuss the individualized nature of retirement spending and the flexibility retirees have in controlling their expenses. The key takeaway is to consider inflation in retirement planning but to also be thoughtful and realistic about its potential impact.


    John: Inflation has been a hot topic in the news over the last year. One question is how big of an impact will it have on your retirement? We're going to talk about reasons why it might have a big impact and why it might not have nearly as big of an impact as you think in your retirement on today's episode of Friends Talk Financial Planning. Hi, I'm John Scherer, and I run a fee-only financial planning practice in Middleton, Wisconsin. 

    Bridget: And I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois. Before we talk inflation, we just want to remind people to please subscribe. It helps us grow our YouTube channel, helps more people find us, and helps our influence on YouTube. So John, let's talk inflation. How do you approach this with you? 

    John: Bridget and I had a discussion with a couple of peers recently, talk about Friends Talk Financial planning, right? 😊 And one of our colleagues was using some new software for how to think about inflation. And we had a great discussion about what does that mean in retirement? There're a couple of schools of thought. One is that inflation does not have nearly as large of an impact on retirees as it does on other people due to various factors, including things like housing is not as big of an issue for retirees. 

    And then the other school of thought is that things go up over time and we need to factor that in. So to answer your question, Bridget, I do think that things are going to cost more in general in 20 years for our clients than they do today. It's based on history. There're no guarantees on those things, but I do include inflation as I think about our future dollars. But then on the flip side, also when we’re talking about investment returns, I use historical inflation returns, and I use historical average investment returns. 

    And as I think about it, probably neither one of those two is the right thing. Inflation is not going to be exactly what it was. Inflation has averaged something around 3 or 4%. But golly, if you retired in the 1960s, you had a lot higher inflation from 1965 to 1985. People still remember having double digit mortgage rates, a high double digit. And if you retired in 1995 until 2015, you had a lot lower inflation. So the average might be 3 or 4%. 

    But shoot, you had a lot lower inflation on that. Just like the average returns don't necessarily mean anything for individuals in our experiences, but it does give us some framework to think about. So that's how I look at it with folks, just sort of projecting out those numbers. And I will say that we talked a little bit before we hit record here, and those numbers get pretty big. I think back to when my folks bought the house that I grew up in back in 1978. 

    They paid $55,000 for it. Fast forward 40, 45 years and cars cost that much and not even luxury cars. And to think about projecting that forward and saying, “Hey, what does a new house cost today?” And when my kids are my age, are they going to be buying $200,000 cars? It just blows my mind. And at the same time, I think that there is some reality to that. So I have those conversations with folks. 

    Bridget: I'd like to unpack a couple of things that you talked about. I find your approach really interesting. So the first thing that I like about your approach is that if you're going to adjust for inflation, you want to use the actual inflation, which I think historically is about 2.9%, but then you need to look up your investment returns. So when you're looking up your investment returns, they're generally a lot higher than people are willing to stomach actually putting on the portfolio. 

    And you can correct me if I'm wrong, but most portfolios earn at least 8%, even if they're like 50/50 bonds and stocks. So the number that you're putting in there wow, that might make you feel uncomfortable if you actually use the numbers that are historically accurate. So if you're going to use the inflation number, you got to use the returns number. 

    John: Yeah, I think that's exactly right. And we had this discussion with our colleague where the software was suggesting historical inflation, but then using returns that were a third or more less than what historical averages, and you go, “Well, listen, if we assume regular inflation and really low returns based on history well, that's not telling the fair story.” I think you're exactly right about the returns for something like a 50/50 stock bond portfolio or a 60/40. I know that when we run our software, we're looking at something around 9%. 

    Bridget: Yeah, exactly. A lot of people are uncomfortable if I put 9% in there. They think that sounds too good to be true. And I think, “Well, okay.”

    John: Maybe they're right, Bridget, I don't argue. I get that. But we have to use similar context. We can't use one side versus the other because the risk of that right. One risk is if we're not being conservative enough and we run out of money. That's not a good thing. But the other risk is if we're super conservative and double kind of trimming it on both ends sort of thing, we're going to end up dying with a big mattress full of money. And it’s not most people's goal to conserve and to cut down their enjoyment now to have a giant pot of money when they’re 90 years old. It's a slightly less damaging risk, but I think it's a real risk to over save by being too conservative with our thought process. 

    Bridget: And that dying on a big mattress full of money doesn't sound that comfortable either. I've been shopping for mattresses😊

    John: Bridget, I got one thing. I know that you take a little bit of a different approach, or at least you did in the past, and don’t really factor inflation into retirement projections. And I wonder if you could just talk a little bit about why. I think that's a really interesting way to look at it. And there are some reasons why that makes sense, why that could be a good approach. 

    Bridget: I've taken the approach that I learned from Bert Whitehead, so I'm going to quote my source. He was an innovator, a pioneer in the field, and started in the 70s with financial planning, so he started during stagflation. And so, his approach was inflation is overrated. The motivator for using inflation, and especially that formula that we were just talking about, “We'll use inflation, but then we'll deflate returns,” was created by people who make money off having your money under their umbrella; they want you to over save. 

    They're motivated for you to die with a lot more money than you need to. I don't think that's everybody's conscious motivation, but I think that's something that's worth consideration. The other factor I think is underrated is how you actually spend in retirement. So let's break that down a little bit. First of all, Social Security is indexed for inflation, not exactly, but quite a bit. That means a major part of people's income that they use for spending when they're in retirement is already going to go up if there is inflation.

    It depends on the pension, but a lot of people's pensions are going to be indexed for inflation. Okay, so there're those two factors and then there's most people. If you got a paid off house, I'm not a proponent of a paid off house, but if you got a paid off house, or if you got a house with a mortgage, that's inflation protection. You are locked in, your payment is locked in. Sure, property tax can increase, but if you've paid off your house, your payment is zero. 

    That's locked in. Same with if you have a mortgage, your payment is locked in. And the only thing that can happen to it generally is it goes down if you've got a fixed mortgage and you refinance. So a major source of income and a major source of spending are locked in already when you're retired. So those are factors that people don't talk about, and I have another one, too, but I figured you want to make some comments on these ones. 

    John: I think that's a really interesting point. For some folks, 25 or 50% of their retirement cash flow comes from Social Security or pensions, and Social Security is for sure indexed for inflation. One thing you've brought up, as we've talked about buying your first TV when you were living in your own apartment. And if I remember right, something it cost something like $500 and probably for a giant 24-inch TV or 27-inch TV back in those days. And some things like televisions that have gone down over time. 

    I sort of benchmarked things like the price of a new car. I mentioned that earlier. Are prices of new cars going to continue to go up in the future? Maybe, maybe not. But you look at things like electronics and there's other things where you go, “They've gotten cheaper and cheaper and cheaper over time.” So how does that impact retirement projections as some things certainly go down? And then there're other things that come in, like back in 1995 there wasn't a great big technology bill for our cell phones and those things. 

    So some things like the cost of televisions go way down. Other things come into play. And for me that just reminds me that it's so individualized to our situations, and we don't know what that is. We've got a client who, though some people drive less in retirement than when they're working, drives way more because of some of his hobbies. So how can you apply those things to individualized circumstances? And the future might not always be what the past was. That's an important factor to keep in mind. 

    Bridget: Well, there’s one thing I just want to bring up to people when we talk about cars. I went to a continuing education and the person who's now the head of the Energy Department was speaking, and she said that the predictions were that car prices and the cost of driving would come down dramatically with electric cars and that would happen by 2030. Now, I don't know if that's true, but it seemed less likely when I saw her speak a couple of years ago than it does today because the demand for electric cars is so great. 

    So that's one thing. The other thing is I think we're getting you brought up a point that I think dovetails with one of Bert Whitehead's points. It’s that when you're in retirement you've got a lot more flexibility to do things if you've got the money. For instance, do I redo my bathroom? Well, if I've got some money, yeah. If I don't have any money, no. Do I go to earlier dinner at the same place or a later dinner? You've got more flexibility to actually control your spending when you're in retirement than beforehand. 

    John: Yeah, I think that's maybe a great place to sort of wrap up. And I really appreciate you talking about that flexibility because that is a big factor. And so, what's the takeaway? Is inflation going to be a factor in retirement? There’s probably some factor. There's a case to be made for that. There's also a case to be made that it's not nearly what the Consumer Price Index is and probably not as scary for a retiree as it might be made to appear. 

    And to really individualize is important, looking at your situation and where things are and not taking a hardline stance by saying, “I'm going to be spending more and more money until I'm 100 years old” or “It's not a factor at all,” but to be thoughtful about how you think about retirement. That's kind of my takeaway. I don't know if you have any final thoughts on it, Bridget.

    Bridget: Yeah. For me, one of the reasons that I don’t use inflation but then lower my investment returns to something people are more comfortable with is because I want to communicate. I feel like when we use inflation adjusted numbers, it starts getting so big that people's minds are just blown up, and they give up. 

    John: $200,000 car, right? 

    Bridget: Yeah. And so, again, it's all part of asking, “What am I comfortable with?” and really being conscious of it rather than just being driven by fear. So with that, I'm Bridget Sullivan Mermel, and I've got a fee-only financial planning practice in Chicago, Illinois. 

    John: And I'm John Scherer. I have a fee-only financial planning practice in Middleton, Wisconsin. Both Bridget and my firms are taking on new clients, so if you're interested, we'd love to hear from you. If you'd like to find an advisor that's in your local area, we're both members of the Alliance of Comprehensive Planners, and you can find more people that think like Bridget, and I do by visiting acplanners.org. 

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