How to Hedge Against Inflation in Retirement

Retirement and inflation can be a dangerous combination. Over time, even relatively low inflation rates can eat away at your retirement savings.

The United States Federal Reserve attempts to keep inflation at just 2%. But the 12-month inflation rate in the United States reached 8.5% in March 2022, according to market and consumer data company Statista.

Even the relatively low levels of inflation experienced in the two decades before the COVID-19 pandemic could have a significant impact on your retirement savings. For example, if you were living on $60,000 a year in 2000, you would have needed $91,747 a year in 2020 just to have the same buying power you had in 2000, according to the inflation calculator from the U.S. Bureau of Labor Statistics.

And just a 3% inflation rate over the next 20 years would mean you’d need more than $108,000 per year to have as much buying power then as $60,000 per year can buy you now.

Social Security plays an important role in many people’s retirement finances. The benefits are evaluated each year and are usually adjusted based on an annual cost-of-living adjustment (COLA) to keep up with inflation. But this adjustment can occur after a year of rising costs — so you may feel the pinch of a higher cost of living many months before you actually benefit from the annual adjustment.

During periods of inflation, your retirement savings plans — such as 401(k) plans and IRAs — may require more watching, monitoring and adjusting on your part.

Inflation is one of the biggest risks in retirement. Several different strategies can help you hedge against inflation in retirement. These strategies may focus on stretching your fixed retirement income to cover rising prices, or they may involve adjusting your retirement account investments to keep up with the rising cost of living.

Diversification can protect your retirement savings while hedging against inflation.

Instead of relying on one retirement fund, this strategy involves diversifying your savings through different investments to guard against risk — including the risk of inflation.

For years, financial advisors suggested a 60/40 retirement savings strategy — 60% of your 401(k) or IRA contributions should be in stocks, and the other 40% should be invested in bonds. While the returns were often significant prior to the pandemic, inflation could erode these gains in the future.

Inflation is a major factor in any retirement planning calculation. Professional financial planners use sophisticated software to estimate how inflation may affect your bottom line in retirement. If you work with a financial advisor, be sure you have a clear understanding of how the advisor is calculating inflation rates.

Plan now for a higher inflation rate when you get to retirement.

If your retirement savings calculations relied on the low 2% to 2.5% inflation rate of the decades prior to the pandemic, you may want to consider raising your inflation rate estimations to 4% or 5% in retirement.

For example, if you were planning to retire with $60,000 in annual retirement income, a 5% inflation rate would mean you’ll need a $3,000 per year raise starting in your second year of retirement in order to maintain your buying power from the first year of your retirement.

Typically, health care costs will be your single biggest retirement expense. The average couple retiring at age 65 will need $285,000 to cover their health costs in retirement, according to a 2019 study by Fidelity Investments. Note that this is a total over the entirety of the average retirement, but does not include costs such as long-term care or general elder care.

Premiums for Medicare plans will account for 76% to 82% of your health care costs in retirement, according to a 2021 report from T. Rowe Price.
If you retire before you’re eligible for Medicare at age 65, the cost of private insurance can add even more expenses. Additionally, fewer employers are offering health insurance for retirees.

You might prepare for any gap in medical coverage with a health savings account (HSA). These types of savings accounts are offered with high-deductible health insurance plans and let you sock away money for medical bills. You can continue to use the money in your HSA after you go on Medicare, but you will no longer be able to contribute to an HSA once you enroll in Medicare. You can also, however, explore a Medicare supplemental insurance (Medigap) plan or a Medicare Advantage plan to fill coverage gaps left by Original Medicare.

Additional ways to save money on health care costs include negotiating payment plans with health care providers and enrolling in prescription drug discount programs such as GoodRx to save on prescription medications.

Americans are retiring with credit card debt, mortgages and even student loan debt that can create a significant strain on retirement income. Once you retire, every dollar you spend to pay down your debt is a dollar taken out of your retirement savings.

Having an adjustable-rate mortgage at the time you retire can be especially bad in times of high inflation because your mortgage rate will increase.

Prioritize having your high-interest debts paid off before you retire, if at all possible.

In the end, you may need to work longer than you planned to before you’re able to retire. Extending your working years can keep your income stream flowing and prevent you from having to tap into as much of your retirement savings.

While you may not need to keep up the daily grind, you could consider stepping down to part-time work.

You may even want to consider a different line of work. Learning a new job in a different industry or sector is a learning experience that can help keep your mind young.

If you’ve gotten comfortable with low inflation rates after the Great Recession, you may want to take a closer look at your stocks, bonds and other investments during periods of higher inflation.

Stocks have historically outperformed inflation in the long run, even though inflation tends to make investors nervous and drives down stock prices in the short term.

You may want to consider investments with guaranteed returns — such as annuities or other life insurance products — as well as products that may provide adjustments for future inflation.

Certain types of annuities can provide a hedge against inflation.

In addition, annuities may offer higher rates during times of rising inflation. As the Fed raises interest rates to combat inflation, the rates for annuities also rise.

Typically, bonds suffer in times of rising inflation, as bonds usually have a fixed rate of return. When inflation rises, it erodes the purchasing power of the future payout on the bond. However, there are some exceptions.

Additional types of investments may also outperform inflation.