On this page
Working out how much you need to save during your working years to enjoy a good standard of living in retirement is always a complex task, but with inflation rearing its ugly head again the task is that much harder.
Rising costs have been hard to miss recently, with most of us now looking for ways to cut our regular expenses – whether they’re fuel, energy, groceries or housing costs.
In the September 2022 quarter the annual inflation rate hit an eye-watering 7.3%, more than double the 3.0% rate of a year earlier. This prompted the Reserve Bank to go all-out hiking interest rates in an attempt to tame the inflation genie.
Although there’s been lots of discussion about the cost-of-living crisis, just how is inflation defined and calculated? And why does it matter when it comes to planning your retirement?
What is inflation?
Simply put, inflation is the increase in the prices of goods and services across the economy. When prices go up, you need more money to buy the same things.
The most well-known measure of inflation is the Consumer Price Index (CPI), which every quarter measures the percentage change in the price of a basket of goods and services consumed by Aussie households. This hypothetical basket is tracked by the Australian Bureau of Statistics (ABS) and includes thousands of consumable items from food and drink to petrol, housing, health, education and childcare.
Inflation is an important concept to understand because if your income – both while you are working and in retirement – stays the same but prices are going up, you have less purchasing power. That means you may have to cut your spending to balance your budget, or increase your hours of work.
It also reduces the future value of income you receive from your super and other investments in retirement, which may make it more difficult to maintain the standard of living you’d hoped to have in retirement.
Why inflation matters in retirement
For retirees inflation figures can sound pretty dry and uninteresting, but what they measure has a significant impact on how much you enjoy your retirement and how much time you spend worrying about your finances.
Although the quarterly CPI rose substantially in 2022, our inflation rate has bounced around significantly over the past 70 years. It reached an all-time high of 23.9% in the fourth quarter of 1951 and a record low of -1.3% in the second quarter of 1962.
Australian annual CPI movement (%)
Source: Australian Bureau of Statistics
Although our current inflation rate is low compared to the 1951 peak, the September 2022 CPI figure of 7.3% was the highest since 1990. Food and non-alcoholic beverages rose 9.0% between September 2021 and September 2022, housing costs lifted 10.5% and transport rose 9.2%.
Even though we’re all affected by rising inflation, when you’re working your wage can rise as the cost-of-living increases, so inflation may be less of a concern. But once you retire and start living off your savings, inflation continues to eat away at your purchasing power and there’s not much you can do about it.
Inflation is also a challenge because the living costs for retiree households are often skewed towards the areas experiencing the biggest price rises.
According to the Head of Prices Statistics at the ABS, Michelle Marquardt, age pensioner households have been particularly hurt by increases in food and non-alcoholic beverages, as grocery food items make up a higher proportion of their overall expenditure compared to other types of households. They are also “more affected by increases in housing costs, as they have relatively higher expenditure levels on utilities, maintenance and repair, and property rates.”
3 ways inflation affects your retirement savings
1. Inflation erodes the value of your money
Over time, inflation is a thief when it comes to your buying power. As a retiree, the value of your assets slowly goes down as the costs of goods and services you need to buy to live on goes up.
For example, if you retired in 1999 with the healthy lump sum of $500,000, you would have been pretty happy. But a basket of goods and services valued at $500,000 in 1999–2000 would have cost you $884,047.53 to buy in 2021–22.
That’s a 76.8% rise in costs over 22 years due to the average annual inflation rate of 2.6% over that period, according to figures from the RBA’s Inflation Calculator. This means every dollar you spend today buys considerably less than it did 20-odd years ago.
If the current average annual inflation rate of 2.6% over the past 20 year persists over the next 20 years, your $5 coffee today will cost $8.35 in 20 years’ time (2043). If the average annual inflation rate rises to 3%, your daily coffee could cost $9.03.
Another way to see the impact of inflation in retirement is to see how many years your lump sum will last given different inflation rates:
|Low inflation rate
|Medium inflation rate
|Medium inflation rate
|Annual inflation rate
|Lump sum at retirement
|Annual income drawn down in retirement
|Return on investments
|4% per year
|4% per year
|4% per year
|Years to lump sum being exhausted
Source: Author using Noel Whittaker’s Retirement Drawdown Calculator
2. Government benefits generally don’t keep pace
The Age Pension and allowance rates are indexed twice a year to help retiree incomes keep pace with rises in living costs. Indexation of the Age Pension rate is linked to movements in prices and wages, while allowance rates are linked to the CPI.
Although this sounds good, it doesn’t mean full and part age pensioners are completely protected against the impact of inflation. Many observers believe the twice-yearly cost-of-living adjustments to the Age Pension don’t fully compensate retirees for the impact of inflation. It’s important to remember Age Pension increases lag any rise in prices, as fortnightly payments only increases after the ABS has declared the inflation rate for the two preceding quarters.
Age Pension payment rates are only indexed to maintain their real value so they have the same purchasing power as costs increase. They don’t provide an increase in the purchasing power of households receiving an Age Pension.
As mentioned above, inflation affects retiree household differently from households on higher incomes, so a CPI-linked increase to the Age Pension may not accurately reflect the cost increases you experience in retirement.
This is illustrated by research undertaken by the South Australian Council of Social Service in the year to June 2021, which found the living cost index for SA age pensioners rose by 2.3%, compared to the generic CPI rise of 3.8% nationally and 2.8% in Adelaide. The 20 March 2021 increase in the fortnightly Age Pension rate, however, was only 0.9% for single age pensioners ($8.40 increase on the previous $944.30 fortnightly total rate, rising to $952.70).
3. Inflation can make real returns negative
Inflation also cuts your investment returns and can make some investment assets less attractive. It can even see you receive a negative real investment return.
When the impact of inflation is factored into investment returns, you may find you are receiving a much lower real return on your savings than you think. For example, if you invest in a term deposit paying 4% and the annual inflation rate is averaging 2.6%, your real investment return is effectively 1.4%. If the inflation rate is even higher, your return can be negative and your savings will erode, not increase.
Returns from shares and property generally outpace inflation, but these investments come with more risk. Other investment options to fight the impact of inflation can include inflation-linked bonds. While inflation is only one of many investment risks to consider, and diversification is always recommended, retirees need to keep it front of mind when reviewing their investment portfolio.
Watch for inflation in retirement forecasts
Nearly all large super funds offer tools for calculating your likely future retirement balance and income. But it’s important to understand the assumptions used to create these forecasts, as they can vary.
Forecasts from calculators should always be treated with caution as they are not crystal balls. They are only as good as the various assumptions they make about the future – particularly about inflation.
ASIC recognises the significant impact inflation assumptions can have on your retirement forecasts, so it tightened the rules in this area. The regulator now publishes its own estimated annual rise in the cost-of-living and super funds must use this inflation assumption in their online calculators. The rate is reviewed and updated each year.
Requiring super funds to use uniform assumptions about future inflation rates in their calculators helps create more accurate forecasts and makes it easier for you to compare income forecasts from different funds.
If your super fund chooses not to use ASIC’s annual inflation estimate, it must clearly disclose this to you. It must also explain the implications of the inflation rate the fund has chosen to use in its place.