In 2024, the Social Security cost-of-living adjustment (COLA) is expected to be 3.2%, which is significantly lower than the 8.7% increase seen this year. This smaller increase is reflective of the cooling of consumer prices, but it's important to note that inflation remains a constant risk in retirement planning. While Social Security benefits are adjusted annually for inflation, they may only cover a portion of your retirement spending. Over the course of a retirement that could span several decades, inflation can erode the purchasing power of your other assets, potentially forcing you to spend down your savings more quickly and threatening your standard of living.
The impact of inflation on you will depend on your specific circumstances. Social Security benefits tend to replace a higher percentage of preretirement income for middle- and lower-income retirees, providing more protection against inflation. Additionally, for those living in low-cost parts of the country, Social Security benefits may cover a larger share of living expenses. On the other hand, major expenses such as healthcare and housing can significantly impact your exposure to inflation. Older households tend to spend more on healthcare and less on food and transportation, making housing the largest category of expense for most retirees. Whether you own or rent your home also plays a role in your financial security, as rising property taxes and maintenance costs can affect homeowners, while renters are more exposed to rising rents.
Fortunately, there are portfolio strategies available to help mitigate inflation risk. Holding equities (stocks) in your retirement portfolio can offer some degree of protection, as historically, stocks have outpaced inflation over the long term. Vanguard, for example, advises clients to maintain a balanced portfolio of 50% stocks and 50% bonds in the early years of retirement. It's important to acknowledge that stocks are not a foolproof hedge against inflation, as there may be years when stocks are down while inflation remains high. Additionally, the rate at which you withdraw funds from your portfolio is crucial in managing inflation risk. Researchers have debated the "safe withdrawal rate" for years, considering factors such as the real market return and the potential impact of tough market conditions during the early years of retirement. As a conservative approach, a burn rate of 3% or less is often deemed safe for portfolios that continue to hold some level of equities.
The timing of when you claim Social Security benefits also matters. Social Security's automatic COLA provides retirees with an inflation hedge that is unavailable through other means. Delaying the claiming of Social Security benefits can increase your monthly income. You can start claiming retirement benefits as early as 62, but the annual benefit amount increases for each year you wait until 70. Claiming at full retirement age (currently 66 and a few months for most people) is worth 33% more in monthly income compared to claiming at 62, and claiming at age 70 is worth 76% more. By delaying your claim, you will also see larger dollar increases when future COLAs are calculated against a higher benefit amount. In fact, many experts consider delaying Social Security benefits until age 70 as the primary strategy, as it offers the best route to boost real income in retirement.
Other income products, such as annuities and inflation-adjusted bonds, can also be considered to supplement retirement income and provide protection against inflation. Private-sector defined benefit plans (pensions) generally do not come with built-in COLAs, so the real value of their income streams tends to decline over time. Commercial annuities, however, may offer generous payout rates, although these rates typically don't have COLA riders tied to the Consumer Price Index. Treasury inflation-protected securities (TIPS) are another option, with their principal value rising or falling to keep pace with inflation. TIPS ladders, where staggered bonds are created to mature at regular intervals, can be a strategy to manage TIPS effectively. Additionally, I bonds, which are U.S. Treasuries linked to both a fixed rate and inflation, offer another option for investors.
Lastly, home equity can be a valuable source of wealth that can be tapped if inflation significantly impacts other assets. Many retirees choose to sell their homes and move to a less expensive location, unlocking equity in the process. Reverse mortgages are another option for utilizing home equity, although they may come with complexity and high fees.
In summary, while Social Security benefits provide some protection against inflation, they may not cover all of your retirement expenses. It's important to consider other strategies, such as holding equities, delaying Social Security benefits, utilizing income products like annuities and inflation-adjusted bonds, and tapping into home equity when necessary. By combining these approaches and continually assessing your retirement plan, you can better manage the impact of inflation and maintain your standard of living throughout your retirement years.