Authored this article as a public service to San Diego residents on behalf of Financial Planning Association of San Diego (5/16/2011).
Q: My husband and I are planning on retiring in a few years and we were able to weather this rough recession by being proactive with our financial plan. First, how does inflation work? And with the risk of inflation upon the economy, what steps and adjustments can we make to our spending and overall plan to keep us in line with our retirement goals and objectives?
A: Inflation is the rise in prices of goods and services and subsequent fall in your purchasing power. Quite simply, the $100 you saved one year ago could only purchase approximately $97.50 in goods and services today. Inflation is measured for consumers by the Consumer Price Index or CPI. You can find information on CPI and inflation measures on the website for the Bureau of Labor Statistics (www.bls.gov/cpi). Now that we have roughly gone over how inflation works we need to indentify the different steps that you can take to protect your financial plan by adjusting for inflation.
Revisit your Budget and Spending Plan
First thing that you and your husband should do is to sit down together and go over your monthly budget and spending plan. You can get a free Spending Plan worksheet at www.fpanet.org. Take a look at the different categories and measure the differences from a year ago. Which categories seem to be rising? From there you both may want to forecast as to where these expenses may be for the short and long term. After projecting out for inflation, I encourage you to reassess your cash outflows to see if anything can be cut back or eliminated. Another question you may want to address is; what were the inflation assumptions when the plan was created or last reviewed? Your plan’s inflation variable may need to be adjusted for an accurate long-term projection to see if you are still in line with your retirement goals and objectives.
Pay down more or pay off your credit card debt
Historically, a rise in inflation is paired with a rise in interest rates. You both should try to reduce or eliminate the usage of your credit cards. If at all possible, use them for emergency purposes only. The problem here is that you are not only paying a higher price for goods and services during inflation, but you may be paying more in interest on that amount as well. After revising your spending plan, you may find some areas to reduce spending. I recommend redirecting these funds towards paying more of the balance of your credit card debt and pay off your credit cards if these goals are feasible.
Save More!
It is only fair that the amount you save each month receives an increase along with all the rest, right? If you plan on saving the same amount each year, you are not really saving the same amount due to the fall in the purchasing power of your dollars. Increase your savings by at least the rate of inflation. For example, if you save $3,000 a year and the inflation rate is 2.5%, try increasing your savings to $3,075 to keep pace.
Time to take a closer look at your portfolio – Be mindful of your bonds!
Review your current portfolio and make adjustments to try to outpace inflation (within the parameters of your investment objectives). If you have a portfolio that has concentrated positions in fixed income and cash, you both may have some difficulty meeting your investment objectives. Interest rates and Bond prices are inversely related. During an inflationary period when interest rates rise, the prices of bonds will drop. So bonds held in your current portfolio may lose value as newer bonds being issued may be paying a higher rate. There should be a strategic approach in allocating bonds throughout your portfolio. Longer-term bonds are more susceptible to interest rate, so the recommended approach would be to weigh your bond holdings towards shorter duration bonds. In addition to using shorter duration bonds, there should be a concentrated position in Treasury Inflation Protected Securities (TIPS). These securities are backed by the U.S. government and keep pace with inflation by adjusting to the fluctuations in the Consumer Price Index. Once you both properly review your investment goals and objectives, then you can make the adjustments to diversify your portfolio to address inflation.
Disclosure:
Securities and Investment Advisory Services offered through Capital Analysts Incorporated, Member FINRA/SIPC. Scripps Tax & Financial Group, Inc. and Capital Analysts Incorporated are independent non-affiliated entities. Capital Analysts Incorporated does not provide tax or legal advice services.
*This communication is strictly intended for individuals residing in the state(s) of CA. No offers may be made or accepted from any resident outside the specific states referenced.