In this guide
For the past couple of years, most of us have become only too familiar with the terms high inflation and cost-of-living crisis. Fortunately, the inflation rate appears to be moderating, with the Reserve Bank becoming cautiously optimistic it may have tamed the inflation genie.
In the December 2023 quarter, the Consumer Price Index (CPI) – a measure of inflation – dropped back to 4.1%. The January 2024 monthly CPI was down to 3.4%, which is less than half the 7.5% monthly figure a year earlier.
Although inflation is easing, the recent pain created by rising prices has highlighted the importance of this key economic indicator for those in retirement and those approaching the end of their working life.
What is inflation?
Despite endless discussions about Australia’s recent inflation rate, many people are still confused about what it actually is and how it’s calculated.
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.
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The most well-known measure of inflation is the Consumer Price Index (CPI), which every quarter (and now monthly too) measures the percentage change in the price of a basket of goods and services consumed by Australian 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.
Source: Australian Bureau of Statistics
While inflation can seem a geeky concept, it’s an important one to understand because it can reduce your purchasing power if your income – both while you are working and in retirement – stays the same while prices are going up.
Why inflation matters in retirement
In retirement, high inflation reduces the future value of the income you receive from your super and other investments, which makes it more difficult to achieve or maintain the standard of living you’d hoped to have when you finish working. It’s also likely to increase the amount of time you spend worrying about your finances.
Although the quarterly CPI rose substantially in 2022, over the past 20 years the CPI has bounced around quite a lot. These movements have reflected changes in the Australian economy and international events like the COVID pandemic and the GFC in 2008.
Annual and quarterly CPI rate (%) 2000–22
Source: Australian Bureau of Statistics
Even though all households are 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 finite 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.
Back in 2022 when the inflation rate was rising, the Head of Prices Statistics at the ABS, Michelle Marquardt, noted age pensioner households are 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.”
The picture is slightly different for self-funded retirees, as the December 2023 Selected Living Cost Indexes highlighted. While age pensioners saw a 4.4% annual change in their living costs, self-funded retirees experienced only a 4.0% annual change.
In the December 2023 quarter, age pensioner recorded higher (up 0.8%) living costs than in the previous quarter mainly due to increases in electricity costs. Self-funded retirees, however, had a smaller rise (up 0.5%) due to a fall in their housing costs, with mortgage interest and tobacco making a lower proportion of their expenditure.
Living Cost Indexes (LCIs) by household type, quarterly movement (%) December 2023
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Source: Australian Bureau of Statistics
3 ways inflation affects your retirement savings
1. Inflation erodes the value of your money
Over time, rising inflation acts as a quiet thief stealing your buying power. As a retiree, the value of your assets slowly goes down, while at the same time the cost of the 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 would have cost you $982,279.87 to buy in 2023.
That’s a 96.5% rise in costs over 24 years due to the average annual inflation rate of 2.9% 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 2.9% over the past 24 years persists over the next 24 years, your $5 coffee today will cost $9.93 in 24 years’ time (2048). If the average annual inflation rate rises to 3%, your daily coffee could cost $10.16.
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 | High inflation rate | |
|---|---|---|---|
| Annual inflation rate | 1% | 3.5% | 7% |
| Lump sum at retirement | $750,000 | $750,000 | $750,000 |
| Annual income drawn down in retirement | $55,000 | $55,000 | $55,000 |
| Return on investments | 5% per year | 5% per year | 5% per year |
| Years to lump sum being exhausted | 20 | 16 | 13 |
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 (September and March) 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 means full and part age pensioners are not 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 the rising cost of living.
As many retirees have found out in recent years, Age Pension increases lag any rise in prices, as fortnightly payments only increase after the ABS has declared the inflation rate for the two preceding quarters.
This has created real pain for many retirees struggling to pay higher bills with the same level of fortnightly pension.
When looking at how comfortable you’re likely to be in retirement, it’s worth noting Age Pension payment rates are only indexed to maintain their real value so they have the same purchasing power as costs increase. They are not designed to provide an increase in the purchasing power of a household receiving an Age Pension.
As the ABS table above shows, inflation affects retiree households (both self-funded retirees and age pensioners) differently from other households. Over the year to December 2023, the ABS found age pensioners living costs rose by 4.4%, while costs for self-funded retirees rose by 4.0%. Living costs for employees increased by 6.9%, while the generic national CPI rose 4.1%.
These inflation rises were higher than the 20 September 2023 increase in the maximum fortnightly Age Pension rate, which was only 3.07% a fortnight. Single age pensioners received an additional $32.70, with couples receiving $49.20.
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 return on your savings than you think. For example, if you invest in a term deposit paying 4.5% and the annual inflation rate is averaging 2.9%, your real investment return is effectively 1.6%. If the inflation rate is even higher, your real return could be negative and your savings will be eroding, not increasing.
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, retirees should always keep inflation in mind when reviewing their investment portfolio and its performance.
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 these 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 when it comes to 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 are required to use this inflation assumption in their online calculators. This 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.
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