How Inflation-Proof Is Your Retirement Income?

Retirement savings and other investments

Investments in an individual retirement account or 401(k) plan are not adjusted for inflation. They increase or decrease in value as the market rises and falls, and they protect against higher prices only to the extent that your rate of return matches or exceeds the rate of inflation.

However, once you are making withdrawals from the account, you can adjust the amount you take out to cover the cost of inflation.

For example, one common withdrawal strategy recommends taking out 4 percent of your retirement savings in the first year of retirement and adjusting for inflation in subsequent years. So, if 4 percent of your retirement savings is $20,000 and inflation is running at 3 percent, you would make your next withdrawal $20,600 ($600 being 3 percent of $20,000). In effect, Chen says, you can use your retirement account to “give yourself that COLA.”

This approach does carry some major risks. One is that you could “draw down too fast and run out of money,” Chen says. Another is that bigger withdrawals can hurt you when the market is down, locking in losses when stock prices are low and reducing how much you can recover when they rebound.

Some investment funds feature stocks that pay dividends. These can provide a predictable stream of income and “help mitigate some of the losses” from inflation, says Dan Cronin, founder and wealth adviser for Lifestyle Wealth Management in Kailua, Hawaii.

There are also investments designed with inflation in mind. The interest rate on I Bonds, issued by the U.S. Department of the Treasury, is adjusted twice a year to reflect changes in consumer prices. With another federal investment product, Treasury Inflation-Protected Securities (TIPS), the principal can rise with inflation, meaning interest payments can grow, too.

Pensions

While traditional workplace pensions have declined considerably as a source of retirement income in recent decades, 30 percent of older adults have one, according to U.S. Census Bureau data. Whether a pension payout accounts for inflation depends upon the organization that provides it.

Pensions from private companies typically do not have a COLA, says Craig Copeland, director of wealth benefits research for the Employee Benefit Research Institute. Many public-sector pensions do, he says, but the adjustment is often capped at a specific level.

“Some of them are like, they’ll cover the first 3 percent,” Copeland says. “Above that, it won’t be covered.” So, if inflation is running at 2 percent, you’d get a 2 percent pension increase, but if prices rise by 4 percent, your pension payments go up by the maximum 3 percent.

“As the inflation rate comes down, the government pension is more likely to cover most of it,” Copeland adds. “The problem with inflation risk in older age is that it compounds. That high-inflation period will still have an impact, even if you're better covered the next year, because you weren't covered the year before.”

Annuities

For those looking for guaranteed income in retirement, annuities could be appealing. When you buy an annuity, typically by paying a large lump sum to an insurance company, the money is invested with the promise that you will receive regular payments in the future.

Some annuities have a cost-of-living provision that provides an annual percentage hike as a hedge against inflation. For example, rather than your payouts being a fixed amount, they might increase by 3 percent each year. However, annuities with inflation protection typically have lower payouts and higher fees than those without.

Savings accounts

While savings accounts, money market funds and certificates of deposit (CDs) are a safe place to stash money you might need in the short term, don’t expect their interest rates to keep up with inflation, Cronin says. That means their purchasing power will likely decrease during a high-inflation period (although the interest-rate hikes the Federal Reserve used to tamp down the recent inflation spike leveled the field somewhat for much of 2023). 

You may be able to minimize the effect of inflation on CDs by choosing short-term certificates. Your money is not locked in for an extended period, giving you the option of putting it elsewhere, such as in the stock market, where it might get a larger return, although at a higher risk.