How Inflation Impacts Your Purchasing Power Over Time

Inflation is one of the most important forces to understand when planning for your financial future. Even when your income and savings balance appear to be growing, rising prices can gradually reduce what your money can actually buy.

That’s why financial planning isn’t just about accumulating dollars. It’s about preserving and growing your purchasing power — the amount of goods and services your money can afford over time.

What Is Inflation?

Inflation refers to the general increase in prices for goods and services over time. As prices rise, each dollar buys a little less than it did before.

For example, imagine that $100 is enough to cover a week’s worth of groceries today. If prices rise by 3% per year, those same groceries could cost roughly $103 next year. After several years of similar inflation, the difference becomes much more significant.

Inflation doesn’t necessarily affect every product or household expense equally. Housing, healthcare, education, food, energy and transportation can all experience different rates of price increases. But over long periods, even relatively modest inflation can have a substantial effect on your finances.

The Long-Term Effect of Inflation

Inflation becomes particularly important when you’re thinking about long-term goals such as retirement.

Consider a hypothetical 3% annual inflation rate. Something that costs $50,000 today would cost approximately $67,195 in 10 years and about $90,306 in 20 years if prices increased at that rate consistently.

The reverse is also important: $100,000 in 20 years would have the purchasing power of only about $55,368 in today’s dollars at 3% annual inflation.

In other words, having the same number of dollars in the future does not necessarily mean having the same financial resources.

Why Inflation Matters for Retirement Planning

Inflation can be especially challenging during retirement because retirees often live on a combination of savings, investments, Social Security and other income sources.

Suppose you estimate that you’ll need $80,000 per year to maintain your lifestyle when you retire. If inflation averages 3% annually, your expenses could be substantially higher after 10 or 20 years.

This is why a retirement plan should account for future expenses, rather than simply using today’s prices.

A financial plan can help you estimate how much you may need to accumulate, how your income could change over time and how your investment strategy might keep pace with rising costs.

Inflation and Your Savings

Cash and savings accounts can provide valuable stability and liquidity, but inflation creates an important consideration: your return after inflation.

For example, if a savings account earns 2% while inflation averages 3%, your money is growing in dollar terms but losing approximately 1% of its purchasing power per year before considering taxes.

This doesn’t mean you should avoid cash. Emergency savings and short-term financial goals generally require liquidity and stability. Instead, it means it’s important to distinguish between money you need to preserve and money you need to grow.

Related: The Cash Pivot: What to Do as Yields Melt Away

Investing With Inflation in Mind

For long-term goals, many investors use a diversified portfolio of investments with the potential to generate returns that exceed inflation over time.

Stocks, bonds, real estate and other investments can play different roles in a portfolio. The appropriate mix depends on factors such as your time horizon, risk tolerance, income needs and financial goals.

There are no guarantees that investments will outpace inflation every year. Markets fluctuate, and some investments can lose value. But for long-term financial planning, focusing solely on the amount of money you accumulate without considering inflation can create an incomplete picture.

Inflation Doesn’t Affect Everyone the Same Way

Your personal inflation rate may differ from the headline inflation rate you see in the news.

For example, a household that spends a large portion of its budget on housing and healthcare may experience different price changes than a household that spends more on travel, entertainment or other categories.

Your stage of life matters, too. A young family may be particularly sensitive to housing, childcare and education costs, while a retiree may be more concerned about healthcare, housing and everyday living expenses.

Understanding where your money goes can help you build a more realistic financial plan.

Related Reading: How to Budget for Yearly Travel

How to Protect Your Buying Power

There is no single strategy that eliminates the effects of inflation, but several financial planning practices can help.

1. Build an inflation-aware budget.

Instead of assuming your current expenses will remain unchanged, consider how major costs could change over the next 5, 10 or 20 years.

2. Set long-term goals in future dollars.

If you’re planning for retirement, education or another distant goal, estimate what that goal may cost when you actually need the money.

3. Maintain an appropriate emergency fund.

Keeping accessible savings can help you handle unexpected expenses without being forced to sell long-term investments at an unfavorable time.

4. Diversify your investments.

A diversified portfolio can provide exposure to different types of assets and sources of potential return.

5. Review your plan regularly.

Inflation, investment returns, income, taxes and spending habits can all change. Reviewing your plan periodically can help you adjust before small differences become large ones.

Inflation may seem like a small change from year to year, but its cumulative effect can be significant. Over decades, rising prices can substantially reduce the purchasing power of money that isn’t growing fast enough to keep pace.

That’s why successful financial planning looks beyond the question, “How much money will I have?” It also asks, “What will that money be worth when I need it?”

By incorporating inflation into your savings, investment and retirement strategies, you can make more realistic decisions today and improve your chances of maintaining your desired lifestyle in the future.

Bautis Financial LLC is a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.