How inflation affects your retirement income forecast

While you’re working, your wages generally rise as the cost of goods and services rise, so inflation is less of a concern. But when you retire and start living off your savings, inflation starts gradually robbing you of income.

The quarterly CPI published by the Australian Bureau of Statistics measures changes in the price of a ‘basket’ of goods and services commonly bought by households. Australia’s inflation rate averaged 4.97% from 1951 until 2019, reaching an all-time high of 23.90% in the fourth quarter of 1951 and a record low of -1.30% in the second quarter of 1962.

3 ways inflation affects your retirement savings

Although Australia’s current inflation rate is very low, it’s likely someone retiring today will face higher inflation at some point in the years ahead as inflation moves back towards its long-term average.

This means it’s important to understand how inflation affects your retirement savings, with the three main impacts being:

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 total value of your assets slowly goes down, but the costs of the goods and services you need to buy to live on goes up.

For example, if you retired in 2000 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 2000 would now cost you $792,584.82 to buy.

That’s a 58.5% total change in cost over the past 18 years due to the average annual inflation rate of 2.6% over that period, according to figures from the RBA’s Inflation Calculator.

Another way to look at it, is to see the impact different inflation rates will have on how many years your lump sum will last:

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 for retirees for the impact of inflation.

According to research by the South Australian Council of Social Service, over the past year (March Qtr 2018 – March Qtr 2019), the living cost index for SA age pensioners rose by 1.4%, compared to the generic CPI rise of 1.3% nationally. The 20 March 2019 increase in the minimum fortnightly Age Pension rate, however, was only 1.08% for single age pensioners ($9.90 increase on the previous $916.30 fortnightly rate, rising to $926.20).

Although the percentage difference is not large, over time age pensioners definitely feel the impact of inflation on their household budget.

3. Inflation can make real returns negative

Inflation makes some investment assets less attractive, as it eats away the investment return you receive from them. The impact of inflation can even result in a negative real investment return.

When the impact of inflation is factored into low returns from term deposits and government bonds, investors may receive a negative real return. For example, if you only receive 2% for a term deposit and the inflation rate is averaging 2.6%, your real investment return is effectively -0.6%.

Shares are one asset class that generally outpaces inflation, but these investments come with more risk. Other investment options to fight the impact of inflation can include inflation-linked bonds. Retirees may need to invest in a mix of asset classes to beat the drag of inflation on their retirement income.

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.

Forecast 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 knows the significance inflation assumptions have for retirement forecasts, so it’s tightening the rules in this area.

The regulator is keen to see greater uniformity in the inflation assumptions used by retirement calculators to help fund members better compare forecasts.

ASIC now requires funds to use its estimated annual rise in the cost of living as the inflation assumption for calculators. This rate will be reviewed and updated each year.

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.