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The Real Threat of Inflation in Retirement

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What You Need to Know

  • A closer look at recent CPI data shows that the surge in prices may not be that worrying for retirees.
  • Higher housing costs had wealthier retirees bidding against workers vying for a better lifestyle in a post-COVID world.
  • A hidden cost of inflation: Tax thresholds, like for Medicare Part B, mean extra dollars of earned income are worth less.

The risk of inflation in retirement is the risk that one’s nest egg won’t fund an expected lifestyle. According to the Bureau of Labor Statistics, the 0.9% increase in June was higher than any month since June 2007, resulting in an increase in the consumer price index for urban consumers (CPI-U) of 5.4% over the last 12 months.

A closer look at the data shows that the price increase may not be that worrying for retirees. Much of the price increase can be explained by a post-pandemic increase in demand for transportation.

Energy prices, including the price of gasoline and fuel oil, returned to pre-pandemic levels, resulting in a 12-month price increase of 45%. The price of used cars rose 45% over the year, and by an astounding 10% in the months of April and June 2021.

While workers appear to be facing much higher prices, spending categories that matter to average retirees saw only modest price increases. The cost of food (at home and away from home) rose only 2.4% over the year. The cost of medical care services rose just 1.0%, and medical care commodities fell 2.2%. Electricity costs rose by only 3.8%.

The rise in prices for urban consumers might end up being a boon for retirees whose lifestyle didn’t get that much more expensive in 2021. Social Security recipients saw just a 1.3% bump in their cost-of-living adjustment for 2021, but current estimates are as high as 6.1% for 2022. 

Social Security COLAs: CPI-W vs. CPI-E

Some have criticized the use of a price index that measures the cost of living of urban wage-earners to capture increases in the cost of living for retirees. A recent bill proposed by Rep. John Garamendi, a California Democrat, calls for a transition from the CPI-W to the so-called CPI-E, which measures price increases for elderly consumers.

According to Andrew Biggs, senior fellow at the American Enterprise Institute, this change would have increased growth in Social Security income checks in recent decades.

“The CPI-E has tended to find inflation about 0.2 percentage points higher than the CPI-W, and that seems to be true if we look back over the last 10 years or if we look back until 1982, the earliest year for which we have CPI-E data,” he said. “So while there are some years in which the CPI-E shows virtually the same inflation as the CPI-W, in general it’s a bit higher.”

The CPI-E is constructed to capture the cost of inflation in retirement, which Biggs thinks is a move in the right direction: “The thing the CPI-E does right is to look at the prices of goods purchased by older Americans rather than working-age consumers.”

But the CPI-E may also overstate the true increase in expenses for seniors if they decide to switch to chicken if beef prices rise. Biggs notes that the CPI-E “doesn’t account for the way consumers change their buying habits in response to changing prices. The so-called ‘chain weighted’ CPI is designed to do that, and it tends to find lower inflation than either the CPI-E or the CPI-W that’s currently used to calculate COLAs.” 

The CPI also might overstate the impact of increases in housing costs. According to Biggs, “around 80% of seniors own their homes, which means that rising home values make them richer, but in the CPI, housing inflation makes seniors appear poorer. When all of this is combined, I suspect that overall inflation for retirees is somewhat lower than is measured using the CPI-W that’s currently used, and even more so relative to the CPI-E.”

Biggs’ point about the cost of housing makes sense if, like most retirees, they simply remain in the same home they lived in when they worked. Many wealthier retirees save for retirement in the hope that they can afford to move to a warmer climate, or a location near the beach. For these more fortunate retirees, home-price inflation could have a big impact on the lifestyle they hoped to lead.

A significant source of inflation over the last year came from price increases in housing rents driven by a rise in home prices. As it turns out, this rise didn’t affect all retirees equally; it was especially high for wealthier retirees who suddenly found themselves bidding with workers eager to capture a better lifestyle in a world where they didn’t necessarily need to live near the office.

Home-Price Inflation

The National Association of Realtors estimates that home prices have increased by 24% in the last year. But the rise in home prices appears to have been driven by a migration of higher-income, wealthy workers away from higher-priced urban areas to many locales favored by retirees.

Areas such as Austin, Texas, and Boise, Idaho, saw real estate prices rise by more than 30% during the pandemic. Since buyers of these homes tended to have far higher credit scores than average, it is unlikely that the markets will cool down as quickly as previous real estate booms have. After all, the number of truly desirable places to live in the United States is finite.

In a recent Morningstar Magazine interview, Larry Siegel, director of research at the CFA Institute; Jonathan Guyton, principal at Cornerstone Wealth Advisors; John Rekenthaler, vice president of research at Morningstar, and I discussed the prospect of inflation having a disproportionate impact on the kinds of retirees who are most likely to be financial planning clients.

Siegel’s rent for his apartment on the beach in California increased by 40% over the last year. Prices in my favorite retirement spots like Pacific Grove, California, and Taos, New Mexico, have each doubled over the last decade according to data from Zillow. Retirees who had set a goal of, say, $1 million to fund a dream home on the beach would find themselves priced out of the market by the time they reached retirement. 

Increases in the price of milk and bread for average urban consumers don’t resemble the cost-of-living increases faced by wealthier retirees seeing far higher prices when bidding for homes in exclusive locations with remote technology workers. And retirees who moved to these areas before prices spiked face the prospect of an unanticipated jump in property taxes that can wreak havoc on a budget.

Steve Parrish, former insurance executive and an adjunct professor at The American College, says that he and his wife “cringe every time we hear about sales in our town-home association. Growth is not important to us — we own to enjoy our residences, not to invest. The problem is increased valuations drive up property taxes, and that comes directly out of our wallets.”

Asset Inflation

One of the dangers of setting retirement savings goals is that a worker will retire as soon as they meet a certain 401(k) balance. According to a recent report by the Retirement Equity Lab, 1.7 million more workers retired during the pandemic than expected based on recent trends.

Among more educated workers, fewer than expected retired before age 65, but there was a 3.2% increase in retirements among educated retirees over 65. Many in this group were able to retire because the rapid increase in asset prices made them feel as if they had enough.

Unfortunately, if these retirees hope to live on income from these investments, they will feel the effects of asset inflation. Asset inflation should also affect the expected growth in portfolios of bonds and stocks. A 50/50 portfolio of 10-year U.S. Treasury bonds and the S&P 500 produces exactly 75% less income today than it did 10 years ago, in July 2011.

In other words, $1 million today will produce the same annual dividends and interest income from a balanced portfolio as $250,000 did for a retiree in 2011. Retirees who reach for yield by taking greater risk in credit markets are facing spreads between risky corporate high-yield bonds and Treasury bonds lower than they were before the pandemic, despite a likely tapering in bond buying by the Fed in the coming months.

At the current cyclically adjusted price-to-earnings (CAPE) ratio (38), stocks are more expensive today than they have been at any time in U.S. history other than the tail end of the tech bubble in late 1999/early 2000. Since 1995, the monthly Shiller CAPE ratio has predicted future 10-year stock returns with surprisingly little variation (an R-squared of over 90%).

At today’s high valuations, the predicted total stock market return is about 2% annually, and 10-year annual returns have never been higher than 5% in U.S. history when stocks are expensive, as they are today.

Asset inflation presents an equally significant threat to retiree lifestyles. If inflation adversely affects the ability to fund an expected lifestyle using a retirement nest egg, then a rise in the price of goods and services will have the same impact as a rise in the price of investments used to pay for goods and services. Both will prevent a retiree from living as well as they’d hoped.

Tax Thresholds and a Loss of Control

A hidden cost of inflation is what Parrish refers to as the “threshold” nature of taxation. “If inflation causes wages to go up, that may throw you into a higher threshold and end up costing you money — specifically, Medicare Part B.

You get $1 more in modified adjusted gross income, and you end up with a Part B premium that’s as much as 40% higher. Others are the net investment income tax, at 3.8%. That hits at $250K for married-filing-jointly couples, and hasn’t been increased since 2010.”

If a retiree needs to take on additional income to afford the lifestyle they hoped to lead, such thresholds can reduce the amount of income they keep from each extra dollar earned.  

For wealthier retirees, the most unsettling aspect about inflation is a loss of control. Retirement means walking away from earned income, and with it the ability to compensate for unanticipated changes in the market. 

Giving up a job means a loss in what Parrish refers to as “human capital,” or the ability to reenter the workforce and make back some of the lifestyle lost due to higher prices. “That leaves them with few options to stay up with inflation,” Parrish says.

For wealthier workers hoping to match the lifestyle they had before retirement, modest increases in Social Security won’t be enough to make up for a 20% increase in the price of a home they expected to buy or a jump in property taxes.

“Stocks may be helpful, but that’s subject to market risk beyond their control,” Parrish says. “And probably most of their other assets are fixed in nature. It’s a control issue. Once human capital is gone, so is any semblance of control over one’s financial future.”  


Michael Finke is professor of wealth management at The American College of Financial Services.