Inflation and Savings

When the average person thinks about inflation, the first thing that comes to mind an increase in the Cost of Living i.e. that items they purchase regularly keep getting more and more expensive. While this is true, an even greater concern regarding inflation is its impact on savings and financial planning.

Inflation Hurts Savings Buying Power

Nest egg savings—RambergMediaImages (Flickr.com)

Inflation hurts consumer buying power, because increased costs mean spending more to purchase the same items. What you put into a savings account today, at current interest rates (which are approximately 1% APR at the time of this writing), will only buy half as much in 20 years as it does now if you figure the inflation rate to be an average of 3.75% each year. In other words, a basic savings account will not be able to keep up with inflation at current interest rates. Ultimately, your savings account will provide a negative return on your investment as long as inflation continues at a level greater than the return on your investment, meaning your money will lose its value even though you aren’t spending it. To make matters worse you will be charged taxes on the interest or capital gains even though your money is actually losing value.

Inflation Increases Spending

People who fear that inflation will soon decrease their buying power are more likely to spend now, before their money loses its value. Instead of waiting a few more months to buy a new car, many will dip into their savings (or take a loan) to purchase it now, reasoning that their money is “worth more” now than it will be later. This decision not only depletes their savings, but encourages people to buy things they normally wouldn’t and go into debt.

Debt

When inflation makes your money less valuable and you watch your saving dwindle before your eyes, the temptation is to live on credit. After all yu reason, I can pay back the loan with “cheaper dollars”. Credit may provide temporary relief, but it is even more costly over time. Consider the fact that inflation increases at an average rate of 3.75% each year, but credit cards may charge an interest rate of 16% or more. Unless you’re able to pay off the card in full each month, you will find yourself falling deeper and deeper into debt. That is the polar opposite of saving and an illogical non-solution to the decrease in your buying power.

Inflation Hinders Retirement Planning

Inflation also makes retirement planning more difficult because the amount needed to live after retirement continues to rise and the level of inflation is uncertain. After adjusting for the cost of inflation as well as the trend of people living longer, one soon realizes that saving for retirement is an expensive feat. The old standby goal of saving a million dollars for retirement becomes a laughably low goal in light of inflation. Consider that if you have a $1 million dollar retirement nest egg earning 6% with 3% inflation and you spend $150,000 per year your nest egg will be depleted in 7 years. If you retire at 65 that means you are broke by 72.

If you reduce your expenditures to $100,000 per year your nest egg will be gone in 11 years. On the other hand if you reduce your living expenses to $50,000 your $1 million retirement fund will last 30 years. Assuming that you retire at 65 and don’t have any major medical expenses and no major set-backs from stock market losses, that nest egg will last until you are 95. Remember this is liquid assets it doesn’t include money you can’t spend like the value of your house (unless you plan on taking out a “reverse mortgage”).

Inflation means more than a rise in the price of bread or gasoline; it impacts savings from a number of directions.

Inflation and Savings

Inflation Hurts Savings Buying Power

Inflation Increases Spending

Debt

Inflation Hinders Retirement Planning

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