“Inflation is when you pay $15 for a $10 haircut that used to cost $5 when you had hair.” –– Former baseball player Sam Ewing
This quote is amusing – and it is also instructive, because it is quite outdated due to inflation. According to one recent estimate, the average cost of a haircut for men last year was $28, while another source gives a range of $20 to $40.
Savvy people know that inflation is always there, to varying degrees, and that over time it erodes the purchasing power of our dollar. This can be especially important for retirees. For example, imagine you retire at age 62. If inflation averages 3% per year for the next 25 years, what cost you $100 at age 62 will cost you about $209 at age 87 (and possibly with another decade to go).
So if you plan to buy a new car for $35,000 now, it could cost you $50,000 or even $70,000 in the future. Anyone thinking about retirement planning (and we all should) should take inflation into account.
Social security and inflation
When it comes to Social Security and inflation, there’s both good news and bad news. First, Social Security does indeed protect recipients from inflation — to some extent. It does this through cost-of-living adjustments (COLAs) that occur almost every year. Some people think of these as annual “raises,” but they’re not a true increase in your purchasing power. They just increase your income to keep up with the ever-decreasing purchasing power of the dollar.
These COLAs have averaged about 2.6% over the past two decades, but have occasionally been much higher or lower. Check out some recent Social Security COLAs:
|
Year |
COLA |
|---|---|
|
2024 |
3.2% |
|
2023 |
8.7% |
|
2022 |
5.9% |
|
2021 |
1.3% |
|
2020 |
1.6% |
|
2019 |
2.8% |
|
2018 |
2% |
|
2017 |
0.3% |
|
2016 |
0% |
|
2015 |
1.7% |
Data source: Social Security Administration.
The upcoming benefit increase for 2025 will be announced in October and is expected by many to be around 2.6% – close to the long-term average.
Social Security COLA and your pension
So you can expect inflation-related increases in Social Security throughout your retirement—but don’t expect them to be perfect. Because everyone spends differently, the COLA provides a different level of relief each year. For example, if health care costs are rising much faster than other expenses and you much In health care, a COLA based on a wide range of price categories will not fully offset increases in health care costs.
COLAs are based on the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W), which is calculated by the Bureau of Labor Statistics based on changes in average prices of household goods such as food, housing and transportation. Some argue that this is not the best measure of inflation among retirees because it focuses on costs borne by workers rather than spending by retirees.
A better measure for calculating COLAs is the Consumer Price Index for the Elderly (CPI-E), which takes categories such as health care and housing into account more than the CPI-W index. As a result, retirees are estimated to regularly receive a slightly lower COLA than they should.
Take inflation into account when planning for your retirement
Here are some ways you can consider inflation when planning for your retirement:
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Try to save aggressively and invest effectively. You may want to save much more than 10% of your income – and you would do well to invest a large portion of your long-term money in stocks, perhaps through a low-fee S&P500 Index funds.
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Plan conservatively, save more than you think you need, and prepare for the worst. Think about healthcare costs, as these can be significant in retirement.
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Make the most of tax-advantaged retirement accounts like IRAs and 401(k)s. Traditional accounts offer tax deductions up front, while Roth accounts allow you to make tax-free withdrawals in retirement. Paying less in taxes can help offset the effects of inflation.
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Don’t plan to strictly follow a single withdrawal strategy in retirement, such as the helpful but flawed 4 percent rule.
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Consider owning plenty of shares of healthy and growing dividend-paying companies, as dividend payments are often increased regularly and can help you keep pace with or beat inflation.
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Many of us want to set up multiple sources of income for our retirement. This may include Social Security, dividend income, pension income, rental property income, perhaps retirement income, etc. For some people, a reverse mortgage might even make sense.
Even though your Social Security COLAs may not be overwhelming, you should start planning now to maximize your Social Security benefits. The higher they are, the bigger any increase will be. For example, if your benefit check is $2,000, a 3% increase means $60 more, but a 3% increase on a $3,000 benefit means $90 more.
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What Is a Social Security COLA and How It May Affect Your Retirement Plan in 2025 was originally published by The Motley Fool
