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How Does Inflation Affect Retirees?

The price of almost everything will probably go up every year. This is the effect of inflation, a major risk that nobody can predict. In the 1990s, annual inflation was about 3 percent— down from the 1980s, when inflation was about 5 percent, and the 1970s, when it was about 7 percent. Inflation can make a big difference in what a worker will be able to buy after retiring. Table 1 provides examples of how inflation can diminish purchasing power.

Most private pensions are not adjusted every year to provide enough money to counteract the effect of inflation. Many large public employers, such as the U.S. government and some state and local governments, do adjust the amounts of their employees' pensions every year for inflation, and Social Security automatically makes cost-of-living adjustments (COLAs). If most of an Table 2 Average annual investment returns, 1926–1998. SOURCE: Actuarial Foundation, 2000 individual's retirement income will not be automatically adjusted for inflation, the effect of inflation should be considered a serious financial risk and taken into consideration when planning for retirement.

Many people believe they should take no risks with investing their retirement funds, so they keep their money in Treasury bills, certificates of deposit, or money market funds, which they regard as safe. These choices may not be the best alternatives in the long run, however, because such conservative "cash" investments produce the smallest net return after inflation. Historically, stocks offer the highest potential to keep ahead of inflation, as shown in Table 2.

While past results do not guarantee future performance, stocks can play an important long-term role in an investment strategy (unless the future is totally unlike the past). Other ways to fight inflation include annuities or pensions with automatic annual cost-of-living increases or variable annuities invested in a stock market portfolio. Variable annuities require very careful shopping, however, because they can have high costs and fees.

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