Inflation could weigh on retirement savings

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[This article is the third in a three-part series. Part one focused on inflation and compensation. Part two focused on inflation and health care costs.]

IIf inflation rates tend to increase over the next several years, as expected, pension plan sponsors may need to adjust their plan’s investment options. Likewise, plan participants should consider increasing their savings deferral rates, if possible.

As shown in Part 1 of this series, the Consumer Price Index (CPI) in May rose 5% from 12 months earlier, the largest annual increase since August 2008,
the Ministry of Labor reported June 10. In comparison, the CPI
increased 1.6% year-on-year for 2020.

Some economists expect the recent price spike to moderate, but warn that inflation could be significantly higher over the next few years.

While the increase in the cost of living of social security for retirees was 1.3% for 2021,
Kiplinger report that it is
likely to increase to 4.5% next year, the biggest jump since 2008. This is an indication of the challenge facing 401 (k) accounts, which, unlike Social Security, do not automatically adjust to keep pace with inflation.

Even a 3% inflation rate can mean the cost of living can double in 24 years, “Kelly LaVigne, vice president of advanced markets for Allianz Life Insurance Co., wrote on the
Kiplinger website. “It’s no wonder then that more than half (57%) of Americans fear that inflation will make basic retirement spending unaffordable,” he added, citing Allianz Life 2020
Retirement risk preparation study, with responses from 1,000 American adults.

401 (k) Plan Considerations

For employees saving through 401 (k) or similar defined contribution plans, “the impact of higher inflation is being felt by participants in the short term right now, as inflation has pushed up rates. Interest and value of bond funds go down, “said Robert Janson, senior vice president of wealth management and senior portfolio manager at benefits broker GCG Financial, an Alera company.

“In the long run, if inflation persists, participants will need to save more to cope with rising prices for goods and services in the future,” he noted.

According to investment firm TIAA, plan sponsors should “ensure that your investment range is structured appropriately for changing market environments, like rising interest rates. When plan sponsors review their plan’s investment menu, they “may want to… consider the implications of the rate hike and determine if your investment options take this market environment into account.”

“Consider the implications of rising rates and whether your investment options respond to this market environment. “

Plans may consider adding hedges against inflation, such as Treasury Inflation Protected Bond Funds (TIP), for example.

When assessing the performance of target date funds in a rising rate environment, the TIAA has advised plan sponsors to “consider the fund’s downward path,” or how the mix of stocks and bonds change as the target retirement date approaches. For example, “a higher allocation to equities may provide better performance when rates rise, in addition to helping reduce longevity risk,” which is the danger of outlasting retirement savings.

“It’s been so long since we had to worry about inflation that people may have forgotten how to deal with it in terms of retirement investments,” wrote Chris Carosa, editor of FiduciaryNews .com. To help plan members incorporate inflation into their retirement planning, “plan sponsors should keep it simple and let service providers determine if it makes sense” to adjust their investment menus. 401 (k), and if so, what changes might be prudent, he advised.

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Pension plan issues

For defined benefit pension plans, the situation is different.

“Higher inflation, if it persists, will produce higher interest rates, which in turn would reduce pension liabilities. [future payouts that a pension is obligated to make]which is good news for pension plan sponsors, ”said Brian Donohue, partner at pension consulting firm October Three.

Interest rates also have an inverse relationship with lump sum retirement payments: when interest rates rise, the amount of lump sum payments decreases.

“CPI inflation over the past year has been 5%, and interest rates have risen accordingly,” he noted, adding that a typical pension plan has seen its commitments decrease by around 5% since the start of 2021.

“To the extent that the plan’s liabilities are unfunded, a decrease in the liability directly improves the net worth of the business,” Donohue said.

Inflation and higher interest rates can reduce a plan’s investment returns, he noted, “but probably not as much as they reduce liabilities.”

Retirees and interest rates

The Federal Reserve links interest rates to inflation. In recent years, low interest rates on savings accounts, money market funds and short-term bonds have made it difficult for retirees to earn enough interest to supplement Social Security, according to the MarketWatch columnist Paul Randus.

The decline in returns on money market funds and certificates of deposit has been “difficult news for anyone hoping to make the most of their savings, he wrote recently.

As interest rates rise with inflation, retirees would earn more from these investments, but higher prices could also wipe out those short-term gains.

[The other parts of this series are
Inflation’s Return Will Affect Compensation and

Inflation, Other Factors, Drive Up Health Care Costs.
]



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