Minimize inflation’s impact on your retirement savings

Inflation in the Cayman Islands is currently running around 1.2%. In other words, the cost of living is gradually edging higher.

While an inflation rate 1.2% is low by most standards, any amount of inflation will, over the long term, have a negative effect on your pension savings and pension income. Here’s why:

• If your pension savings earn an average annual return of 6%, and inflation averages 2% during the same period, your “real return” after inflation is 4%.

• More importantly, a dollar saved today is expected to lose half its buying power over the next 25 years due to inflation. The impact could be even more dramatic in the future.

If you are currently age 35, retire at age 65 and live to at least age 85, the time span between the first dollar you save and the last dollar of income you receive will be 50 years or more. The impact of inflation over that 50-year period could be dramatic. For example, a $100 basket of consumer goods from 50 years ago, costs $750 today.

While you may be able to retire quite comfortably on $25,000 a year today, you’ll need an income of $50,000 to maintain the same lifestyle 25 years from now and, if trends continue, $185,000 a year by the time you’re 90. Before you start to panic, however, keep in mind that you need an average investment return of just under 3% to double your money in 25 years (and that doesn’t include your regular contributions).

The key message here is that you need to take inflation into account when figuring out how much you need to save for retirement. Historically, there have been extended periods of high inflation (5% to 10%), as well as extended periods of little or no inflation. The rule of thumb for retirement planning purposes is to assume an annual inflation rate of between 2% and 4%.

Fighting inflation

If you are a younger member of the Silver Thatch pension plan, the plan design helps address the issue of inflation. That’s because when you are younger, more of your money will be invested in equities (stocks). While equities tend to carry a higher level of investment risk than bonds, they also offer the prospect of higher investment returns – so it’s more likely your returns will outpace inflation, over the long term.

Of course, over time, the asset mix of your portfolio will slowly shift. As you get closer to retirement, there will be more emphasis on bonds and less emphasis on equities. This means your investment risk will be lower, but so too will your prospects for higher returns. The chance of inflation outpacing investment returns will be increased, particularly if inflation threatens to go up (that’s because higher inflation often results in higher interest rates, which leads to lower bond prices).

That said, there is a way to increase the prospects for higher returns and to protect yourself against inflation – make additional voluntary contributions (AVCs) and invest the money in a portfolio that has a higher level of equities (aggressive, growth or balanced).

Building a base of AVCs will take time; so, if you haven’t started yet, the sooner you start the better. It will not only help protect you from inflation, it could well lead to a bigger pension.