We are in a considerably higher inflation environment than we've seen in decades. While the Federal Reserve initially said the inflation is transitory, the high inflation has spanned more than two years. Over the past several months, high inflation has been a top concern for many people, especially those nearing retirement. Financial advisors are uniquely qualified to address these concerns and help clients plan and stress test for inflation.
Planning for High Inflation
Every advisor uses an inflation assumption when creating a base case for a retirement income plan. While it may be tempting to increase the inflation assumptions to 5%-6% per year, there's a better way. Throughout history, inflationary bouts have been followed by low inflation periods, leading to a much lower average over time. However, the sequence of inflation is essential to clients. If inflation happens early and over a long time at the beginning of retirement, it has a much more damaging effect than if it occurs toward the end of a 30-year retirement. So, when creating a base case, it's best to use a moderate inflation measure of about 2.5%-4%.
Inflation Stress Test for Retirement Income Plans
We can't assume that we will never experience spikes like we're experiencing right now. Income InSight® takes the geometric average inflation from 1975-1984 (the last significant inflationary spike) and applies it to the front end of a retirement plan. This stress test answers the question: Is the plan still on track if significant inflation happens for the next 10 years?
Stress testing helps clients visualize what inflation looks like in relation to their retirement income, particularly if it compounds over time. Sure, the client is probably severely overfunded for a scenario where everything is fine. Still, we rarely get through a 30-year period where everything is fine, and we don't experience any inflation shocks.
Social Security and Inflation
If the client is off track to withstand high inflation, one of the most effective techniques is optimizing Social Security. Over the last decade, the value of Social Security benefits has been estimated primarily by the investment impact. Some people are asking, "Should you spend your income and retirement savings to delay and effectively buy a more significant Social Security benefit?"
While inflation is figured into this, inflationary spikes most often are not. Clients you've optimized Social Security for have a more substantial benefit coming into 2023 due to the 8.7% cost-of-living adjustment. That can significantly impact the sustainability of an overall retirement income plan, particularly if that situation persists for several years. Social Security is a unique asset, and advisors should optimize it on the front end to combat inflation.
Clients who didn't participate in the Social Security planning process for one reason or another may still have options. For example, say your client is a higher wage earner who claimed somewhere around full retirement age. Maybe they hit 65 and were eligible for Medicare, which allowed them to retire. They claimed Social Security benefits immediately because it's the most common thing to do, and they are now 66-years-old. Once they've reached their full retirement age, they can suspend their benefits in exchange for delayed retirement credits. If they suspend their benefits, the underlying benefit will still get today's inflation adjustment, but it will be multiplied by 1.08% for the first year, and if they delay for two years, it will be multiplied by 1.16. That's two years of 8% delayed retirement credits, and they don't compound. The first year of delayed retirement credits is the most valuable, so consider whether a client should suspend their benefits to increase the portion of retirement income supplied by Social Security and thus inflation-adjusted from now on.
It's important to note that if an individual suspends their benefits, it will suspend the benefits of anyone claiming based on their earnings record. If a high-wage earner has a partner claiming spousal benefits due to an insignificant work record, this strategy probably does not make sense.
You can model these Social Security strategies and stress test the plan against inflation in Income InSight. Income InSight is a financial planning platform that has everything advisors need in one place. Create thorough retirement income strategies and quickly show the impact of different retirement decisions. Start a 10-day free trial of Income InSight.