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Underestimating Inflation Is a Big Retirement Mistake

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What You Need to Know

  • A financial plan needs to be updated when market conditions shift. Be realistic regarding inflation expectations.
  • Advisors should run the numbers using different assumptions, such as inflation at 5% or 6% for an extended period.
  • Since there's no way to determine future health care costs, advisors should encourage clients to take out long-term care insurance.

The question advisors hear most often from prospective clients is probably “How much money do I need to have before I can retire?”

Although it’s a question almost everyone asks, there are no easy answers because everyone’s situation is different. While the markets were soaring and inflation was virtually nonexistent, people didn’t seem to worry about that so much.

But now, with inflation and interest rates on the rise, there’s a corollary to that initial question: “How can I be sure I won’t outlive my money?”

That’s really the big question today, because underestimating the impact of inflation is among the biggest mistakes that people planning their retirement can make. 

For anyone pondering those important questions, the first step should be to sit down with their advisor and take a careful look at their financial plan. And if they don’t have an advisor and a plan, they should get one in a hurry.

A financial plan is not a set-it-and-forget-it proposition. It’s a living and breathing document that needs to be nurtured and cared for. When market conditions begin to shift, as they are now, the key is to update that plan based on the current environment and to be realistic with regard to inflation expectations. 

In our own financial planning work with clients, my team and I have always included an inflation factor of 4%. Looking at the short term and the rise in prices over the last six months, that number might seem a bit too conservative, because inflation right now is clearly running higher than 4%. But we need to remember there were years when it was clearly less, and we are planning for the long term.

The inflation rate hasn’t been above 2.5% for the last 10 years, so we continue to believe that 4% is a good projection and we don’t need to update to the current inflation level.

It looks as though the Federal Reserve is ready to start actively fighting inflation as it moves above its projections. We’ll continue to watch the numbers closely and will readjust if conditions change dramatically. 

But while we wait for the Fed to take action and inflation to stabilize, this is a good time for people to sit down with their advisor and make a pragmatic assessment of the totality of their assets. They should be looking at their various retirement cash flows — Social Security, pensions, annuity payments — and factoring those in when determining if they have enough money saved to adequately fund this retirement. 

Advisors should also run the numbers using different assumptions, such as inflation at 5% or 6% for an extended period, or what two or three extra years of working, savings and 401(k) contributions would do for the client’s potential cash flow. A 1% difference, whether it’s in inflation or a rate of return over a 30-year period potential for retirement, can really make a big difference. This kind of planning is important to do while there’s still enough time to make significant changes to the plan. 

Among the things we take into consideration when forecasting is what happens if both members of a married couple live to be 100. That’s the big question mark in the financial planning world — potential average life expectancies as the population ages in tandem with groundbreaking advancements in health care and medical technology to come.

When assessing the impact of inflation, life expectancy cannot be ignored. At my firm, we’ve been projecting out to 100 for years now when drawing up financial plans. Clients in their 40s might chuckle at the thought, but I have one 102-year-old client and several in their mid-90s. 

That’s why it’s important for advisors to help clients have assets that exceed their known future expenses. In the current environment, there’s just no way to determine future health care costs. We know right now what Medicare will cover, what we’re paying for it out of our Social Security and what our supplement is costing, but what do we think those costs will be in 10 or 20 years? 

That’s one of the reasons we encourage clients to take out long-term care insurance; We want to make sure they’re able to offset any potential costs, whether in nursing or assisted living centers, or receiving care at home. 

One of the ways clients can help plan for those unpredictable costs is with an option available from many insurance companies that combine long-term care insurance with a life insurance policy with a fixed premium. This way, the cost is known now, and if the client is fortunate enough not to need it, there will be a death benefit for the surviving spouse, family members or whomever. That option may cost more money now, but it can help mitigate future health care risk.

When working with couples, we try to make sure that if one of the two dies, the survivor doesn’t end up broke for having spent their joint life savings on care for the sick person. I think that’s one reason why these combo policies that fulfill a big need are catching on. 

Regularly sitting down with an advisor, reviewing financial plans and taking action when necessary gives people more flexibility and the ability to consider different options. Will they have to work a few extra years to give themselves the confidence to retire? Do they have to reconsider their goals or their income expectations? Does their plan project the future cost of expenses such as property taxes, health care, income tax, energy and food?

The last thing any advisor wants to see happen is a client getting into their late 80s and finding that they’re almost out of money because of the ravages of inflation. 

When dealing with inflation, as with everything else financially related, it’s important to start with a plan drawn up by a trusted financial advisor. Then, revisit the plan regularly to examine the assumptions outlined in it to see if they’re correct, making adjustments as necessary. And finally, do not panic after a bad month.


Kenneth Van Leeuwen, CFP, is managing director of Van Leeuwen & Co., a wealth management firm he founded in Princeton, New Jersey, in 1997.