Inflation makes prices of goods and services go up over time. It’s why the cost of everyday items changes from year to year. But do your retirement savings in a 401k keep up with the rate of inflation?
A 401k keeps up with inflation if the underlying investment choices aren’t too conservative. A 401K invested in bonds won’t keep up with inflation compared to one tracking the S&P 500. Adjusting the investments in a 401K for inflation from the start helps maintain purchasing power in retirement.
The rest of this article will take a closer look at all you need to know about your 401K and inflation. You’ll also learn why a conservative 401k isn’t beneficial over the long term.
IMPORTANT SIDENOTE: I surveyed 1500+ traders to understand how social trading impacted their trading outcomes. The results shocked my belief system! Read my latest article: ‘Exploring Social Trading: Community, Profit, and Collaboration’ for my in-depth findings through the data collected from this survey!
Table of Contents
How Inflation Affects Your Retirement Savings?
The return on your retirement savings has to match the headline inflation numbers to maintain your purchasing power. Where the returns are lower than the inflation rate, you’re losing purchasing power. If that situation persists over time, your 401k may not be enough to give you the retirement life you originally envisioned.
For example, US inflation numbers jumped from 1.5% in March 2021 to 5.39% in June 2021. If your 401k returns 6% per year, you’re only left with a net gain of 0.40% in purchasing power.
If inflation worsens and the investment doesn’t improve by much, you’ll likely head into the negative for purchasing power.
In that scenario, you’ll end up with a pension pot at retirement that is worth far less than it is today.
How To Ensure Your 401k Keeps Up With Inflation?
The best way to ensure your 401k keeps up with inflation is to invest in both stocks and long-term bonds. These vehicles have outpaced inflation over time.
A stock investment that tracks the S&P 500 returns 10% per year on average since inception. In the last ten years, the average return stands at 13.5%, beating the historical average.
Therefore, a 401k tracking the index has done more than keeping up with it.
Stock-based investments beat inflation over the long term because they give you a stake in businesses that raise prices in line with inflation. These businesses also own physical assets like factories and offices that also go up in line with inflation.
So, your 401k has a higher chance of keeping up with inflation if it features stock investments.
Your investment brochure should itemize how your money is invested. It should also show you historical returns to expect. The expected returns should match or better the current inflation numbers to maintain the value of your 401k savings.
What Is a Conservative 401k Portfolio?
A conservative 401k portfolio is one where the asset allocation leans heavily towards bonds and Certificates of Deposits (CDs). Such 401k portfolios will barely match up to inflation, underperforming in inflation regimes like the current one in the US.
The returns on conservative investments like bonds and CDs are usually safe but rarely high enough to match or outpace inflation.
The average return on CDs is 0.17% per year. For government bonds, the returns are a lot better at 5-6%per year. Assuming the Federal Reserve keeps inflation at the 2% target, a conservative portfolio featuring just both can outpace inflation.
However, if the inflation numbers stay above current levels at more than 5%, there’s a risk of losing purchasing power over time, which makes it harder to get the most out of your 401k.
You may reach your retirement age to find that you need double the money you’ve saved to live the retirement life you planned.
Such a scenario doesn’t look far-fetched. With average inflation of 2.20% per year, $1 saved in 2000 is worth $0.58 today. If the current level of inflation is sustained from now to your retirement age, the math doesn’t look good for conservative 401k accounts.
What’s the Best Solution?
As I mentioned briefly above, the only way to achieve higher growth that doesn’t expose your 401k to excessive risk is to give stock funds a higher allocation in your 401k.
Stock funds will fluctuate a lot more in the short term, but they’re more likely to beat inflation and preserve your purchasing power over the long term.
Stock investments tracking the S&P 500 are generally very common and for good reasons. The index has delivered an average of 10% a year even with the 2008 financial crisis and the COVID-19 pandemic factored in. The index returned 15.76% in 2020—powering through lockdowns and general uncertainty.
How To Make Sure Your 401k Keeps Up With Inflation?
To ensure your 401k keeps up with inflation, you should speak to your financial adviser. They’ll go over your plan and verify your asset allocation. You can move to a new plan if the current one is too conservative.
However, your adviser should decide on what to do. Between taxes, possible penalties, and investment performance, switching your 401k to keep up with inflation might be counterproductive.
If you’re still younger than 40 years of age, you’re more at risk of losing purchasing power, so most advisers will recommend adopting a slightly more aggressive approach to keep potential impacts low.
For people aged 50 and over, the window for aggressive investing may already be too narrow. Sticking with the status quo and adopting other approaches to make your savings last longer might be the better approach.
Ways To Make Your Money Last Longer in Retirement
Here are some tips to make your money last longer in retirement.
Adopt Sustainable Withdrawal
Financial planners recommend budgeting to withdraw 4% of your retirement savings per year when you retire. This way, you can increase the mileage of your savings. Some recommend going a bit lower to 3% if it’s practical to stave off the effects of inflation. Going above the 4% limit increases the chances of running out of money and becoming reliant on social security checks.
Cut Down on Expenses
Utilities, insurance, food, shelter, and transportation are some of the biggest draws on retirement income. Look for ways to lower the money going towards each of them as you edge closer to retirement. You can downsize to a smaller home to reduce taxes, mortgage payments, and utilities. Getting rid of your car can save you around $5,000 a year.
Delay Your Social Security Checks
While you can technically start collecting your retirement benefits at 62, it’s a good idea to delay it until you’re 70. For each year you wait until age 70, your monthly benefit increases. Waiting until that time also increases potential survivor benefits for your spouse. So, waiting an extra eight years to start drawing on your checks can make your total savings last longer.
Delay Your Start of Retirement
Retiring at 67 instead of 62 gives you four more years of full or part-time income to live on. You’ll avoid dipping into your retirement savings, which means extending its mileage even further. Consider earning income for as long as you’re able to without putting your health in jeopardy.
Consider Investing in An Immediate Annuity
Annuity plans provide guaranteed income for a specified number of years in return for upfront payment. If you can afford the lump sum payment, these plans can help make your retirement funds last longer overall. However, this is one of those decisions you should make with your financial adviser.
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Conclusion
The cost of living tends to rise over time, so even mild inflation can take a significant toll on your retirement savings. To make sure you live the life you’ve envisioned in your retirement years, you should account for inflation in your retirement planning.
Go over your investments with your financial adviser to work out how best to make your retirement savings inflation-proof.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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