Inflation has been a hot topic for months and likely will be well into 2022. Its impact is immense; with inflation at its highest level in 40 years and interest rates rising, consumer sentiment is falling.
During retirement inflation is always a concern, even more so now at its highest level since 1982. A Fidelity Investments study shows that 71% of American investors are very concerned about how inflation can impact their preparedness for retirement.
Historically, evidence indicates that inflation will come back to earth; annual inflation rates since 2000 in the United States have usually stayed under 3%. Even so, planning for inflation is imperative when building your retirement plan. Make sure that you're incorporating some projections for inflation and what it will cost to maintain your lifestyle in the future.
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The Bucket System for Retirement
The stock market has historically been one of the best vehicles you can use to help offset inflation, however, that approach often involves a high level of risk – which most retirees are not willing to take. One way to mitigate that risk while protecting against inflation is to create different “buckets” of money. These buckets are often referred to as Now, Soon and Later.
- Now: Often referred to as an emergency fund, this is usually cash inside of a savings account. This is money that you may need unexpectedly at any point in the near future.
- Soon: In retirement, it’s important to set aside a certain number of years’ worth of income (usually 10 years) in a vehicle that is principal protected to produce additional income in retirement. This bucket should typically be established five to 10 years prior to retirement.
- Later: This is the bucket for long-term investments that you won’t need to tap for 10 years or more.
Funding the Now bucket is pretty straightforward. Just open a savings account and start stashing. The other two buckets take a little more planning.
Filling Up Your ‘Soon’ Bucket
Here are some ways you can incorporate the Soon bucket into your retirement plan:
Create a CD ladder
This is a savings strategy in which you invest in several certificates of deposit with staggered maturities. This allows you to capitalize on higher rates on longer-term CDs and keep some funds accessible in the short term, although early withdrawal penalties could apply.
CDs offer a guaranteed rate of return, and if rates are rising, you can reinvest the money from shorter-term CDs into new accounts to lock into higher annual percentage yields. You could, however, be missing out on higher returns from more aggressive investments, such as stocks and bonds.
Build a bond ladder
People build bond ladders to create predictable income streams while managing potential risks from changing interest rates. Interest payments from bonds can provide income until the bonds mature or are called by the issuer. Laddering bonds that mature at different times allows you to diversify the risk of changing interest rates across several bonds.
Keep in mind that ladders should be built with high-quality, noncallable bonds. With interest rates likely to keep rising in 2022 as the Federal Reserve acts against inflation, a bond ladder can be useful in this scenario because it regularly frees up part of your portfolio to take advantage of the higher rates. However, investors need to be aware of bond-related issues, such as risks associated with diversification and default, as well as relatively high costs.
Consider a fixed index annuity
A fixed index annuity is an insurance contract that provides you with income in retirement. Payments are based on stock market index returns, such as the Dow Jones Industrial Average or the S&P 500.
You don't have to worry about large losses with a fixed index annuity during a significant market downturn. Unlike directly investing in the stock market, you're generally protected against losses. But that comes at a cost: Your total returns will be limited, and your contract may charge additional fees. On the plus side, the long-term expected return of a fixed index annuity is higher than other guaranteed accounts, such as a fixed annuity or CD.
The amount of income you'll need in retirement will dictate what type of vehicle you use. Sit down with a financial adviser to talk more about your situation to figure out your best course of action for hedging against inflation.
Finally, Thoughts on Your ‘Later’ Bucket
Once your emergency fund is established and your income needs are met, the last bucket to be filled is the Later bucket. This approach often involves a high level of risk and investments that should be looked at as longer term – such as stock and real estate.
By having your Now and Soon buckets, your Later bucket has the advantage of time. Although this investment approach often has a higher level of risk, it can also be our best hedge against inflation shrinking our retirement!
Dan Dunkin contributed to this article.
Disclaimer
The appearances in Kiplinger were obtained through a PR program. The columnist received assistance from a public relations firm in preparing this piece for submission to Kiplinger.com. Kiplinger was not compensated in any way.