How Inflation Impacts Your 401(k)

Written By: Steve Henderson, CPA, PFS, CFP®, CKA®, Regional Director, Partner

Your gas station visit drains your wallet while filling your tank. Your groceries seem to cost more every week. For older investors, significant inflation was a financial challenge that had almost faded from memory. For younger investors, it’s a term that had little day-to-day relevance. Until today. Inflation suddenly has assumed new importance as it’s risen from the nominal amounts factored into retirement planning for years, reaching levels that now threaten the best-laid plans of many. To appreciate what’s at stake, and learn how to protect your 401(k) from inflation, it helps to start with a quick review of what inflation is and what its consequences can be.

What is inflation?

Having defined it as a “steady and sustained rise in prices,” economist Milton Friedman famously said in a 1963 talk that “Inflation is always and everywhere a monetary phenomenon.” He argued that nowhere on Earth could inflation be found that wasn’t due to a prior increase in the supply of money or its growth rate. This phenomenon is far from new.

During the Roman empire, diluting silver coins with increasing amounts of less valuable metals allowed the government to increase the supply of coins while decreasing their relative value. Inflation ignited as it took more and more coins to equal the value of the same goods and services, eventually contributing to the empire’s decline and fall.

More recently, some of the most rapid price increases in U.S. history occurred during the period from 1965 to 1982 known as “The Great Inflation.” Year-over-year Consumer Price Index inflation was at 13.3% in 1979, when Paul Volcker was appointed Chairman of the Board of Governors of the Federal Reserve. By the following year, Volcker had raised the Federal funds rate to 18%. This triggered a painful but necessary recession leading to an era of constrained inflation, typically below 4%, that has persisted for the next four decades.

Today multiple factors conspire to bring significant inflation back to life. These include spending initiatives by both political parties that pumped lots of dollars into an economy whose consumers had fewer spending opportunities during pandemic restrictions. In addition, reduced production in other countries experiencing their own pandemic lockdowns, as well as labor shortages, trade policy impediments and supply chain constrictions play a role, with knock-on effects such as the chip shortages that have limited the production of new vehicles. At the same time, we’re also dealing with energy-supply limitations due to war and other geopolitical factors, as well as fewer oil and gas leases.

Inflation affects practically everything

Recent U.S. Labor Department statistics show consumer prices in June, 2022 up 9.1% over the previous year—the largest yearly increase since 1981. At the wholesale level, prices were up an even higher 11.3%. What does this mean in terms of your day-to-day spending?

It means that pretty much everything is getting noticeably more expensive—but not at the same rates. Clearly fuel and the transportation that depends on it are leaping. So are food, as well as home prices and rental rates. Surprisingly, medical expenses recently have experienced some of the least inflation, which isn’t usually the case.

It’s worth noting that your personal inflation rate and its impact can differ from the overall published rate. For example, homeowners with fixed-rate or paid-off mortgages may be in better shape than apartment dwellers with rising rental rates. Those with short commutes may experience less inflation in their overall budgets than those with long commutes and hefty fuel bills, other expenses being equal.

On the income side of your financial planning, your stage of life can greatly influence how much impact your personal inflation rate has. Those in retirement, or getting close, may find their fixed-income investments aren’t keeping pace with rising expenses, and cost-of-living raises from work have ceased, or aren’t sufficient if they’re still employed. On the bright side, though, Social Security’s Cost Of Living Adjustment (COLA) for 2023 looks like it could exceed 10%. That’s a good thing, since price increases raise a big related question: how does inflation affect your 401(k)?

How inflation affects 401(k) retirement savings

Inflation not only influences the performance of the individual investments in your 401(k), it also impacts the percentage of assets you’ll need to draw on during each of your retirement years. This is because while inflation is steadily raising the annual cost of living your retirement assets must cover, it’s also affecting the overall economy those assets depend on to grow. Inflation can reduce consumer confidence, leading to reduced spending ultimately reflected in lower stock prices and dividend growth. The rising interest rates used by the Fed to dampen inflation also slow the economy, and may cause a recession that impairs company performance and stock prices. Fixed-income investments may not generate enough interest to keep pace with inflating expenses. And rising interest rates also can quickly depress the value of bond funds—especially longer-duration ones—which may force you to deplete them more quickly if you’re selling shares to cover growing retirement costs.

Protecting your 401(k) against inflation

The question is how to protect your retirement savings and maximize your chances of success when inflation is high and no asset classes look especially promising. You can start by recognizing inflation’s likely consequences, address the things you can control, then look at possible portfolio adjustments that might be helpful—while avoiding radical changes you’ll probably regret later.

Consider that historically we’ve used an inflation rate of roughly 2.5% for projections. The retirement years of most clients look pretty good when that’s applied to the likely returns from their 401(k) investment portfolios. But increase inflation to 5.5% or so with that same portfolio, and there’s a huge impact on the risk that you may outlive your money. And that risk rapidly rises further with even higher sustained rates of inflation.

You can’t control the inflation rate or the markets, but you may be able to improve those odds by extending your income-producing years if you’re still working, and trimming your expenses where possible for a more budget-conscious lifestyle. Working longer not only reduces the number of years your retirement portfolio needs to support you, it also lets you add more to your 401(k), including employer contributions if available.

As for specific investments

Traditionally fixed-income and cash are the last places you want to be when inflation is raging. Unfortunately that’s where emotion often drives investors during stressful times, leading to even greater stress later when the real value of their assets declines. High-yield bonds may offer a more competitive return, but it comes at the cost of higher risk, especially during economic uncertainty. Treasury Inflation-Protected Securities (TIPS) do adjust with inflation to improve their returns, but their principal drops significantly in a rising-rate environment, just like other bonds.

Looking beyond cash and bonds, commodities have the potential to outpace inflation, but their volatility can be a problem when it’s time to sell. Real estate also is considered a possible inflation hedge, again with volatility as a tradeoff.

That brings us to the equities prominent in most 401(k) accounts. Although as inflation gets rolling it also takes its toll on stock valuations, over the longer term many companies have the ability to raise their prices and improve productivity. So unlike bonds and cash, whose face value is fixed and real value declines with inflation, stocks can grow in value and provide some defense. In our current inflationary environment, dividend-paying stocks have held up better than most, even under the additional pressure of a bear market, because of their ability to provide a stream of income along with appreciation potential.

Above all, remain calm and carry on

As headlines shouting “inflation” confront you day after day, how should you respond? By being patient and careful with your portfolio. By ensuring your cash reserves are adequate as things become more expensive. By delaying discretionary expenses, and increasing 401(k) contributions if you’re working. And above all, by avoiding decisions based on emotion. It’s here that a financial advisor is one of your most valuable assets. We can provide customized advice to shield you from making long-term decisions you may later regret. Today’s economic environment is a prime reason to meet with your advisor to review your situation and update your financial plan if necessary. It’s one of the most strategic things you can do to strengthen your defense against inflation and protect your 401(k).

Reach out to one of our advisors today to learn more about financial planning and/or to begin your financial planning journey. Contact Merit Financial Advisors today!

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All investing involves risk including loss of principal. No strategy assures success or protects against loss.