What Causes Inflation and Why it Matters in Retirement
Inflation is a reality in all economies, and it generally occurs for one of two reasons. These are known as "cost-push," or "demand-pull."
Good businesses and companies that want to retain their employees have to insulate them, to some degree, against the falling value of a dollar. This is often referred to as a cost-of-living-adjustment (COLA), and due to these COLA’s few people will generally feel the full effects of these rising costs of living throughout the lifetime of their careers.
The people who do generally feel inflation and who understand its full effects are the elderly, or people living on a fixed financial base of some kind. Here is a brief overview of the two types of inflation, and why you should plan for them in retirement.
When the cost of providing goods or services goes up, businesses pass those increases on to the consumer. There are many inputs to the costs of goods and services – for example, raw materials and lease costs are expenses that are passed down to consumers by way of higher prices. Perhaps the most obvious example would be recent conversations about the national minimum wage. When businesses have to pay their employees $8 an hour, they charge a corresponding amount for their goods or services to cover the cost of wages. If the minimum wage rises to $15, however, businesses will likely raise the price of their goods and services to adjust for the increased wages they have to pay.
There is a question as to whether businesses will be able to raise prices to compensate for ALL of the difference, or if some of the difference will mean that businesses simply become less profitable. In the case where customers are unwilling to pay higher prices, then the business owner would have to come up with a different solution – including possibly taking home a smaller profit. Given some small business profit margins, the businesses that survive such an increase will be stronger, more efficient, and better run overall.
An increase in underlying costs will usually result in some increase in prices. And, from a textbook perspective, there is still a net gain for those who receive the new higher minimum wage, because competition limits the raising of prices. In this case, the net gain in wages is offset by a reduction in business profits.
However, there are other people who do not benefit from a wage increase – and are subjected only to the rising costs. If costs increase a lot, for any reason, people living on a fixed income suffer the affects the most negatively. If prices rise quickly, they have no way to adjust their incomes to accommodate the higher cost of goods.
When the demand for something rises, so does the cost. When there is a shortage of food, gas, water, housing, or any other good or service, this also creates an increase in cost. Whenever there is a surplus of a good or service, it drives prices down. This is why those living in heavily-populated areas, or areas that grow in population, often have to move to a less populous area – where there is less demand – in retirement.
In areas where shortages create higher prices, businesses generally have to adjust their employees’ salaries in order to keep them. This means those still in the workforce are generally not as affected by this type of inflation as those who are unemployed or retired.
It would be much easier for me (living in the San Francisco Bay Area) to retire to my hometown (Rapid City, SD) than it would be for my parents to move to the Bay Area.
Regardless of when it occurs, or how long it lasts, the expanding and contracting of the value of the dollar is an important thing to consider for those planning their retirement. It's not a question of “if” it will happen, but when, how much, and for how long. While you may be able to live perfectly comfortably on $6,500 a month now, that doesn't mean you will still be able to do so in 10 years – at least not without making other changes.
The good news is that the dollar stretches more in different places around the globe, so there are almost always going to be inexpensive places to live. The problem, of course, is how settled you are now – and how badly you want to stay there. If we spend our whole lives in the place where we raised our kids, built our friendships, and engage our communities, then uprooting everything becomes a non-starter. Those relationships are very important for our long-term health and wellbeing.
If you like where you live – and plan on staying there upon retiring – then it's important to develop a good, solid financial plan for dealing with inflation over the course of your life in retirement. It is certainly possible to live on a fixed financial base, but it also takes careful planning – and a great deal of insight into the realities of the declining value of currency (inflation).