Inflation is sky-high — retirement plans aren’t keeping up

Before you head off to join the Great Resignation you may want to think twice before telling your boss to take the job and shove it, as inflation can be real a dream-killer. 

In fact, at the wholesale, producer and consumer levels, inflation has broken records — with some measures, once annualized, exceeding 18 percent. At this rate prices will double every four years.

If one does not account adequately for inflation, visions of retirement with Mai Tai cocktails on the beach will encounter a sad reality of saltine crackers and endless Netflix reruns. In these record-setting times it’s more important than ever to actively utilize updated estimates for inflation — typically implemented by having one’s nominal income stream adjusted for inflation.

Over the last 75 years, inflation has averaged 3 to 4 percent when annualized. Is 5 percent, 6 percent or more the new norm? What if your financial advisor under compensates, or even fails to compensate for future inflation at all?

Typically, your financial advisor will do one of two things to adjust for inflation: either use a historically based average rate of 3 to 4 percent or ignore the issue entirely and use 0 percent, which is far too common. As of the second quarter of this year, both approaches are ill-advised, given the shocking pipeline of inflation data.

Keeping it simple, consider this scenario: You’re 65 years old and plan to live to 100. You’ve already saved $1.2 million for retirement, which begins later today when you’ll make the first of 35 annual withdrawals to support you during retirement. You — and your financial advisor — believe you can earn 7 percent per year on average over the next 35 years.

Sounds good? Not so fast — to combat the adverse impact of inflation, at what rate do you want your annual income to grow? Four percent per year? Six percent per year? More? Less? Zero? What to do? Perhaps those saltine crackers will be on sale.

Unfortunately, the growth rate (G-Factor) of your retirement income stream, whether it’s a rate of 2 percent or 6 percent, is too often overlooked or misunderstood by financial planners — which, in an inflationary environment, will greatly diminish one’s purchasing power over time.

Also, unfortunately, if you apply any modern handheld financial calculator to our prior example, it’ll suggest an annual income of $86,618 per year, with no indexing for inflation. It’s the same income each year. However, if inflation averages 6 percent per year, then in 34 years that $86,618 income level will only provide an equivalent income value of $11,946 today. Yikes, it’s prosperity to poverty, by failing to index for inflation.

If the same scenario is analyzed, except now indexing the retirement income to grow at 6 percent per year, then the first-year income from the $1.2 million retirement plan will be $40,039 and each year’s subsequent income will be 6 percent larger than the prior. Under this plan, in 34 years the annual income becomes $290,326 and it would still buy what $40,039 would buy today — providing a constant level of purchasing power and complete protection from 6 percent inflation at Walmart, with landlords, big oil and from incompetent financial planners.

So, today’s lesson is to ensure that your retirement planner imposes retirement annuity streams that grow — at rates that may be substantial relative to historical inflation norms. And stress-test a variety of inflation assumptions to find your comfort level.

Rodney P. Mock is a professor of accounting and Larry Gorman is a professor of finance at the Orfalea College of Business at California Polytechnic State University. Gorman is the author of the textbook, “Mastering the Fundamentals of Finance, Building Skills and Intuition” (Cognella 2021).