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Inflation’s Impact on Retirement, Taxes and Estate Planning

Six ways to help clients gain peace of mind.

A recent Allianz Life survey found that more Americans see inflation as the greatest threat to their retirement than any other money worry, but advisors, on average, are three times less likely to worry about inflation than their clients are. If inflation is unchecked, it can be one of the biggest destroyers of clients’ financial wealth and dreams. Here are six impactful ways to help clients gain more peace of mind in inflationary times.

1. Help clients calculate their “personal inflation” rate. Each client spends money differently. A 65-year-old retired couple in the suburbs might have two heavily used cars and related costs for insurance, repairs and gas. By contrast, a 65-year-old couple in the city, with the same age, income and health status, might have no cars or one they used to use only for weekend getaways. The price of new and used vehicles, repairs and insurance has increased dramatically since the pandemic and will significantly impact their budget. The city dwellers won’t feel this inflation like the suburbanites will.

You can add significant value by helping clients determine their inflation rate based on the way they actually spend money. This may require the car-reliant couple to choose between increasing their spending to maintain their current lifestyle (and reducing their current plan’s chances of success) or cutting back their lifestyle to maintain the same level of spending. Housing costs are another example. If a couple has a fixed-rate mortgage, their cost of housing is impervious to inflation, except for increases in property taxes, utilities and repairs. On the other hand, renters will face the constant pressure of rising rent plus the cost of utilities. The personal inflation rate will make a big difference.

2. Pay closer attention to cash hoarding. With so much uncertainty in the world today – and money markets paying over 5% -- you may see clients with more than six to 12 months’ worth of living expenses idling away in cash. You need to have a conversation now because their wealth is quietly eroding in the name of peace of mind.

One way to do this is to list your client’s goals for their cash. For example, they may want cash available for unexpected emergencies, a travel fund or savings for a down payment on a home. Next, you can help your client determine how much they need for each goal. If the emergency fund target is based on the client’s living expenses (for example, six months’ worth), you can help walk the client through their budget or expense tracking software to come up with a reasonable number (and ensure it’s in line with the client’s current level of expenses, as some living costs have likely gotten more expensive due to inflation).

3. Pay closer attention to the “sequence of returns” risk. In a recent article, I discussed the sequence of risk. In addition to that issue, there’s the problem of increasing income distributions to cover the rising cost of living. One problem with many retirement planning software programs is that they tend to plug in a constant inflation rate (say 3%) throughout a retirement time horizon. Inflation rates vary greatly throughout a multi-decade retirement. However, if there’s a spike in inflation early in one’s retirement (as those who retired in 2022 and 2023 can attest), pulling more income from the portfolio can devastate your client’s long-term retirement security. If there’s a 10% inflation rate in Year 1 of retirement, the long-term impact will be felt for many years. That first-year inflation rate impacts every future year of spending. So, it would have a bigger impact on the retirement plan than if a big inflation spike occurred in Year 15 or Year 20.

Studies by my American College colleague, Dr. Wade Pfau, demonstrate that failing to account for inflation when determining sustainable withdrawal rates from a retirement portfolio can lead to premature depletion of assets. Pfau’s research suggests adjusting withdrawal rates downward (as low as 2.4% from the traditional 4%) or using inflation-adjusted withdrawals to mitigate this risk.

Think about what this means. A $1 million portfolio that could be distributing $40,000 (4%) a year could be reduced to $24,000 a year in distributions based on Dr. Pfau’s concerns. If your client is 40 years old, this changes the savings trajectory. But what if your client is 65 or 70? There is not much time to add sufficient assets to solve this problem.

4. Expand the discussion of inflation-fighting tools. Many advisors may not adequately diversify their clients’ portfolios to include inflation-hedging assets, such as Treasury Inflation-Protected Securities (TIPS), I-Bonds and real estate investment trusts (REITs). Consider your client’s age and the impact lower returns will have if they’re younger. You might want to consider alternatives to increase the fixed-income portfolio return.

TIPS are very useful for protection against future rises in inflation. As opposed to traditional bonds in which the principal and interest payments are generally fixed and, thus, can be eroded by inflation over time, TIPS are designed to be equivalent in inflation-adjusted value from the date the bonds are issued until they mature.

Series I savings bonds, in addition to paying a fixed interest rate that the Treasury sets, also pay an inflation-adjusted variable rate determined by changes in the inflation rate as measured by the consumer price index. For example, I-bonds issued between May 1, 2023 and Oct. 31, 2024 will have an interest rate of 4.28%, which includes the rate set by the Treasury Department, 1.3%, plus the variable component based on the inflation rate. Remember, there’s generally a $ 10,000-a-year purchase limit, and I-bonds must be held for at least a year, so clients won’t be able to cash them out before a year ends if the rate plunges due to falling inflation. They’ll lose the last three months of interest if you redeem them before five years are up.

REITs have a relatively consistent track record of outperformance against inflation and have outperformed stocks in periods of moderate and high inflation. Yet, REITs have their drawbacks. Many REITs are illiquid, have high expenses and can introduce tax complications that may or may not be worth the inflation protection benefits.

5. Don’t forget about good old stocks. Stocks have proven to be among the most inflation-resistant investments. Stocks (as measured by the S&P 500) have generated an average annual return of 10.2% from 1926 through today, yielding an inflation-adjusted return of +7.10% per year. For clients asking about adding inflation-hedging assets to their portfolios, remind them to look at the inflation-hedging properties of the stocks they already own. For example, a younger client with a portfolio composed of 80% to 90% stocks—and a 30-plus-year retirement time horizon—may already be well protected from inflation without adding other inflation-fighting assets.

For older clients with a shorter investment horizon and presumably a smaller allocation to stocks in their portfolio, explain the difference between:

  • Inflation protection of their savings long-term (which can be provided by the stocks or equity funds they already hold), versus
  • Inflation protection for their income in the short-term (which might involve assets with more of a direct short-term correlation with inflation, about which more is written below)

Selecting and managing a portfolio is a balance among: (1) Security and stability; (2) Inflationary pressures; and (3) Demographics (for example, age, geography and relationship status).

6. Help clients avoid “bracket creep.” While tax brackets are theoretically indexed to inflation, your higher-income clients could be especially susceptible to bracket creep. If their incomes (including retirement income) rise faster than the thresholds for each tax bracket, more of their income falls within the higher tax brackets, causing them to be taxed at higher effective tax rates. Bracket creep gets worse when factoring state taxes into the equation. That means that in those states, any increase in income will likely result in higher effective tax rates.

You can help clients take advantage of tax planning opportunities like “clumping” together charitable donations or switching from Roth IRAs to traditional IRAs or 401(k) contributions. These can ease the effects of higher taxes, especially when higher expenses due to inflation are already eating into their income.  Another opportunity for tax planning stems from the fact that some parts of the Tax Code aren’t indexed to inflation, such as the $10,000 state and local tax deduction, the $250,000 modified adjusted gross income threshold that triggers the $3,000 limit on capital losses that are deductible against ordinary income.

Dr. Guy Baker is the founder of Wealth Teams Alliance (Irvine, Calif).

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