Inflation is a financial force that impacts individuals, families, and the broader economy. What some people don’t know is that when it comes to government pensions, the effects of inflation can be particularly significant. And because many retirees depend on these pensions as a crucial source of income in their post-working years, it’s essential to understand how inflation can erode the value of these payments and what strategies can be employed to mitigate its impact.
At Horizon Planning Group, our experience lies in guiding government employees through the complexities of their government pension choices and helping them prepare for a stable retirement. In this article, we dive into the implications of inflation and provide insights into what you can expect regarding your government benefits.
What Is Inflation?
Inflation is the general increase of prices and goods which can lead to an erosion of your purchasing power over time. It essentially makes every dollar earned worth less today than it was yesterday.
The Consumer Price Index (CPI) is a common measure of inflation. The most recent CPI report from August 2023 shows that inflation has risen 3.7% over the past year. That number is much higher than the typical 2% rise we see in an average year.
So, how does inflation affect your government pension? Well, the answer really depends on whether you are still accruing benefits, or if you have already retired.
The type of retirement plan offered by your employer will determine who assumes responsibility for investment decisions—and therefore who will need to stay on top of inflation. With a defined benefit plan, your employer will manage the investment and bear the risk, so you have little control over performance.
With a defined contribution plan, you choose the investments offered by the plan and then take on the potential risk (and reward) for how your plan performs. The money paid into your plan is invested in various assets throughout the stock market which helps your benefit grow faster than inflation. This is where you’ll want to carefully select your investments to take into account the effects of inflation.
Though the exact rate of return you will earn is specific to your pension plan, the stock market as a whole has averaged roughly a 10% historical return as measured by the S&P 500 Index. Using a more conservative 5% as an example, we can see how inflation affects your pension over time.
At a 5% annual return, your pension would have only grown 1.3% (5% - 3.7%) in inflation-adjusted terms from August 2022 to August 2023. Now imagine that your pension only grew 3% over the course of the year, while inflation remained the same. Your real rate of return would be in the negative! Over time, fluctuating returns and increasing inflation can drastically affect both how much your pension earns as well as how much each dollar is worth when it comes time to retire.
If you have a defined benefit plan, you will receive annuity payments in retirement that are based on the total benefit amount accrued during your working years (contributions and earnings). At this point, you have locked in the value of your plan and you are guaranteed a set income for life. With the more common defined contribution plans, there are no guaranteed minimums or maximums. Your payments are dependent upon your investment returns.
Government employees retiring under the Federal Employee Retirement System (FERS) will also receive cost-of-living adjustments (COLA) that are meant to offset the rate of inflation. However, it doesn’t solve the inflation problem entirely due to provisions in the law. If inflation is 2% or less, your annuity payment will be adjusted by the full COLA. But if inflation is greater than 2%, your annuity payment will get the COLA minus 1%. This 1% difference can have a significant impact on your purchasing power over time, especially because your ability to earn additional income is reduced in retirement.
The 2023 COLA is 7.7% for FERS retirees, the largest increase in 40 years. While this is a substantial increase that will help compensate for the high levels of inflation, retirees must still contend with the rise in healthcare expenses, which often outpaces the everyday inflation that younger consumers face.
Safeguard Your Pension
There are several ways to shield your savings from the risk of inflation. Working longer, contributing to other forms of savings, and diversifying your income are just a few options. But one of the biggest factors in how your government pension will be affected by inflation is deciding when to retire and claim your benefits. This can be a tricky decision, especially in a high-inflation environment.
The pressure to make a decision about when to claim your benefits may feel high, driven by concerns about the impact of inflation and market volatility on your savings. On the other hand, waiting for a more stable market and potentially lower inflation rates to maximize your earnings might be your preference. Regardless of the path you’re considering, the timing of your retirement deserves a comprehensive evaluation of your overall financial strategy.
At Horizon Planning Group, we are equipped to guide you through the complexities of the current high-inflation environment, allowing you to approach retirement with confidence. If you’re interested in discovering how we empower retirees to make well-informed choices for their financial future, don’t hesitate to reach out. Schedule an introductory meeting online or call (770) 627-4157 or email Nick@MyHorizonPG.com to get started.
Nick Marrano is financial advisor at Horizon Planning Group, a full-service financial planning firm committed to always doing what’s right for their clients. With almost 10 years of experience, Nick spends his days serving his military and first responder clients who give their lives to serve others. As a former U.S. Marine, he understands their challenges and desires to help his clients navigate their military benefits and customize a plan to their lifestyle that allows them to pursue their goals with confidence.
Nick has a bachelor’s degree in finances from Kennesaw State University. He lives in Marietta, Georgia, with his wife, daughter, and their two dogs. His favorite things to do are being outdoors with his family, traveling, and completing projects around the house, but he also won’t say no to unwinding with his friends and playing Xbox. Nick cares deeply about his community and gives back by volunteering with the Make-A-Wish Foundation and local charities that support foster-care needs. To learn more about Nick, connect with him on LinkedIn.
This is for educational and informational purposes only and is not research or a recommendation regarding any security or investment strategy.
The information given herein is taken from sources that IFP Advisors, LLC, dba Independent Financial Partners (IFP), IFP Securities LLC, dba Independent Financial Partners (IFP), and its advisors believe to be reliable, but it is not guaranteed by us as to accuracy or completeness. This is for informational purposes only and in no event should be construed as an offer to sell or solicitation of an offer to buy any securities or products. Please consult your tax and/or legal advisor before implementing any tax and/or legal related strategies mentioned in this publication as IFP does not provide tax and/or legal advice. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. This report may not be reproduced, distributed, or published by any person for any purpose without IFP’s express prior written consent.
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