If you want a financially secure retirement, never underestimate the risk posed by increasing inflation rates.
Why is that you ask? Well, let's start with a simple definition of inflation. In very simple 'Financial Bloke' terms, inflation is when the cost of everything just keeps going up each year.
It is measured and tracked by the government and is generally expressed as a percentage increase each year in the Consumer Price Index (CPI). The Reserve Bank of Australia states on its website that the government is targeting an inflation rate of 2-3 per cent per annum, on average, over time.
So why should you worry about inflation? Because the cost of everything rises each year and therefore so do your living expenses. Over time that compounds the longer you are retired. If you base your retirement funding calculations of how much you need to live off for the rest of your life on everything going up each year by say 2.5pc but the actual rate is greater than that, then you run the risk of running out of money much quicker than expected. This means you need a lump sum that will generate an income that increases to keep up with inflation.
Here's a simple example. Assume right now you are 65 and retired and statistically you are expected to live another 20 years (about age 85). Let's say you need $65,000pa for a comfortable retirement and inflation is 2.5pc per annum. By the time you are 85 your cost of living will have increased to $110,000pa.
A competent financial adviser will take that into consideration when developing a financial plan but what happens if inflation isn't 2.5pc pa? What if say the government artificially lowers interest rates for an extended period of time and starts printing truckloads of money? Well, you get inflation and possibly lots of it!
And that, my friends, is terrible bloody news for retirees.
Let's run the numbers for what would happen if the inflation rate moves to say 3.5pc per annum.
Well the cost of living will keep going up at a relatively modest additional 1pc per annum (total of 3.5pc per annum). Instead of needing $110,000 to live annually by age 85 you would need $134,000pa, a whopping $24k per annum extra or 23pc more each year.
That is why if inflation gets out of control, even what seems like small average increases over time can have a significant compounding impact long term.
So, what can you do? Firstly, you need to know how your retirement funding model looks now and what it would look like in a higher inflation world. Then if you know how inflation impacts your model you can get advice on how to protect your retirement funds and give yourself the best chance of a secure retirement.
Sign up for our newsletter to stay up to date.