How Inflation Affects Your Financial Plan and 3 Tips That May Help

financially savvy kids By K. Bridget Schneider, CFP®, CRPC® inflation financial plan blog image

It’s no secret that we are currently feeling the effects of inflation as we buy groceries and fill our gas tanks.  But the recent announcement that inflation has increased 6.8% since last November got me thinking.  That’s the largest 12-month increase in almost forty years.  While someone 60 years of age or older may recall what that time was like, a younger person may have concerns about how inflation affects their financial plan.  Here are some things to consider.

What is Inflation?

Since I’m not an economist I will keep this simple.  The term inflation refers to a progressive increase in the prices of goods and services in the economy.  There can be many causes of this, but the bottom line is that a dollar today buys less than it used to.  Inflation isn’t all bad.  The Federal Reserve targets an average inflation rate of 2% over the long term to meet its objectives for maximum employment and price stability.  However, when we experience a sharp decrease in purchasing power because of a sharp increase in inflation, it’s difficult to think long-term.

How Does Inflation Affect Your Financial Plan?

Someone planning for retirement or other life events often focus on how they will replace the income from a job.  But in my experience, very few initially consider how that income must increase over time to keep up with the cost of living.  A comparison of today’s cost for everyday items like bread or a tank of gas versus those costs from ten or twenty years ago helps show the importance of considering inflation in their plan.  After all, most of us want to be able to enjoy the same things throughout retirement that we do in our working years.

When modeling expenses for a client’s retirement plan, we generally assume a constant level of inflation over the time span of their plan.  The assumed growth rate on their assets is also constant over this time.  But, if inflation rises much more than expected, your expenses also increase more than planned, and you will deplete assets faster.  Without other adjustments, inflation that is higher than you expected could cause you to run out of money in your golden years. 

3 Tips That May Help Protect Against Inflation

Avoid Holding Too Much Cash

It makes sense to keep some cash available for your emergency fund or other short-term purchases in the next few years.  But beyond that, holding too much cash can be a costly mistake.  Over the last several years the rate of return on savings and CDs hasn’t kept up with inflation.  So, while the money in savings is safe from market loss, you are losing purchasing power over time. 

Investing in Equities

Investing can be a way to help your savings keep up with inflation.  Historically equities have performed well during periods of inflation.  While this involves taking some market risk, the longer your time frame before needing the funds, the less likely you are to lose money.  Including equities in your investment holdings will increase the volatility of your portfolio, which means you need to be able to tolerate some ups and downs in the value over the short term.  But by adding companies that may pay dividends you can generate income to the portfolio.  

Re-Evaluate Your Budget

This is a good time to review where your money is going.  You can evaluate your current expenses to determine if there are lower-cost alternatives or areas where you can eliminate or reduce without affecting your quality of life.  We have a free Budget Worksheet on our website to help you get started.

The one thing you should not eliminate is your regular investment plan.  You don’t want to eliminate the one area that has potential for growth only to spend more on those things that offer none. 

Consider delaying purchases for goods or services that are temporarily higher in price due to supply disruption.  It is also good to avoid acquiring debt with variable interest rates when inflation is on the rise.  Initially, that lower interest rate may be tempting.  But the Federal Reserve manipulates short-term interest rates to slow or spur economic activity and control inflation.  When inflation is high, they may increase these rates to slow the economy.  Fixed interest rates on your debt are a good way to hedge because you won’t be caught by rising expenses from the increase in interest rates.  

Summary

While higher rates of inflation can cause problems with your financial plan, it is possible to address them by regularly monitoring your progress and making adjustments as needed.  If you are concerned that inflation is going to increase, you can help mitigate its effects by preparing for cost increases. You can’t control how inflation rises or falls, but you can control your own financial decisions and make choices today that will help you manage inflation tomorrow. 

Consulting a Certified Financial Planner™ professional may be helpful as you consider those adjustments that are appropriate for you.  Be sure to visit our website today or call us at 217-605-8130.  At Connections Financial Advisors, our mission is to help you make more informed decisions to better your financial position and reduce your financial stress. 

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Dividend payments are not guaranteed and may be reduced or eliminated at any time by the company.

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