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Mark Miller: Remaking Retirement

How Much Does High Inflation Really Affect Retirees?

The answer depends on healthcare costs, Social Security benefits, and your own financial circumstances.

It’s a truism that high inflation hits hardest for people on fixed incomes—especially retirees. And seniors are telling pollsters that high inflation is among their top worries.

But the actual impact of inflation on retirees is more complex. It depends in large part on your financial circumstances and age—and on how you manage healthcare costs and Social Security claiming decisions.

Let’s start with a big-picture view on how retirees are feeling these days. Despite the economic turmoil created by the pandemic, higher inflation, and volatile markets, most retirees remain remarkably confident. The latest Retirement Confidence Survey published by the Employee Benefit Research Institute finds that nearly eight in 10 are confident they will have enough money to live comfortably throughout retirement, and one in three are very confident.

Those who are less confident cite inflation as their number-one concern. That reflects the current headlines about very high inflation rates, of course, although even moderate inflation is always an important factor in retirement plans. One hundred dollars—assuming an inflation rate of 2%—would have the same purchasing power as $164 after 25 years.

Moreover, rising healthcare costs can be ruinous for lower-income households. Half of Medicare enrollees had income below $29,650 in 2019, and one in four was living on less than $17,000. Many struggle to meet basic needs, especially in high-cost parts of the country.

How Retirement Spending Changes Over Time

But for more-affluent households, the impact of inflation depends very much on where you are in the life cycle, and how you spend.

Research by JPMorgan Asset Management concludes that average household spending is highest at midlife; older people spend less on all categories except healthcare and charitable contributions. Average annual spending drops from $94,000 among households age 65-69 to $77,000 for those age 80-84. Notably, there’s a bump in spending toward the end of life as healthcare costs accelerate, with the possibility of a long-term care expense.

Among households aged 75 and higher, the researchers found that housing, healthcare, food and beverage, transportation, and charitable contributions make up 84% of spending. Notably, housing is the largest category of spending for this group (38%), and it accounts for a much larger share than healthcare (14%).

Most older Americans own their own homes. If they are carrying a fixed-rate mortgage or own their homes outright, housing costs are immune from inflation, with the exceptions of property taxes, maintenance costs, and utility bills.

“If you’ve paid off your mortgage, or you’re going to do that soon, housing can be one of the areas of cost that decline in retirement,” says Sharon Carson, defined-contribution strategist at JPMorgan.

Morningstar’s Christine Benz noted recently that actual inflation rates can differ significantly among households, and suggested calculating your likely personal rate by category of spending using a spreadsheet tool.

The Critical Role of Social Security

Social Security is a critical source of protection from the impact of inflation.

Unlike nearly all other sources of retirement income, Social Security benefits adjust annually to mirror consumer prices. Social Security makes up a smaller part of total income for high-income households, owing to the progressive nature of the benefit formula, but it’s an important income source nonetheless: JPMorgan calculates that for a retiree who needs to replace 80% of a $150,000 pre-retirement income, Social Security covers 33%.

That means Social Security acts like an inflation-adjusted annuity in your portfolio—and as a such, it makes sense for retirees to maximize their benefits through delayed claiming wherever possible, Carson argues. “Higher-income households are more able to afford waiting to claim, and it’s just crucial to do that,” she says. “The longer you wait, the bigger your monthly benefit will be, and you’re going to get annual cost-of-living adjustments off that larger base for the rest of your life.”

Social Security’s built-in annual cost-of-living adjustment, or COLA, is unique and valuable. Still, retirement policy observers have debated for years the adequacy of the formula used to determine the annual COLA.

Social Security determines the COLA each fall by averaging together the Consumer Price Index for Urban Wage Earners and Clerical Workers, or CPI-W, during the third quarter. Annual COLAs are applied to future benefit amounts in the year that a worker turns age 62—so even if you’re delaying, your future benefit keeps pace with inflation.

Critics note that CPI-W reflects a market basket of goods most relevant to working households. The U.S. Bureau of Labor Statistics has an experimental alternative measure, the CPI-E, which gives more weight to healthcare and other costs more relevant to seniors.

Researchers at the Center for Retirement Research at Boston College noted recently in a research brief that the CPI-E is subject to errors on account of the construction of the index. Notably, it is built using a relatively small sample size.

Over time, it has risen a bit faster than the CPI-W, but it does not always deliver the goods. The CRR researchers note that the 5.9% COLA awarded for 2022 (the highest since the early 1980s) actually would have been just 4.8% as measured by the CPI-E, because it gives less weight to transportation than does the CPI-W. The CPI-E effectively missed the big spike in gas prices last year. Another unusual inflation trend last year that would have reduced a COLA driven by the CPI-E is that medical care prices actually fell four tenths of a percent last year as the novel coronavirus pandemic depressed utilization.

Longer-range healthcare costs present special challenges: Historical costs have risen at a higher rate than overall inflation or economic growth.

In the Medicare program, the average annual growth rate in spending per enrollee has been slower over the past decade (1.9%) than in private-sector insurance plans (2.8%), according to the Kaiser Family Foundation.

Premiums have been jumping. The poster child is this year’s outlandish 14.55% jump in the Part B premium, to $170.10, caused mainly by expected costs of Aduhelm, the controversial Alzheimer’s drug. (Some observers expected that Medicare might announce an unusual midyear reduction in the premium following a decision to cover the drug only in limited circumstances. However, Medicare recently announced that the reduction will instead be factored into the 2023 premium.)

Medicare premiums represented 6% of people’s average Social Security benefit in 2002, according to the KFF; they now represent 10%.

But that’s just part of the story. Overall out-of-pocket costs in Medicare are rising. KFF calculates that over the past 20 years, out-of-pocket costs have gone from 15% of the average Social Security benefit to 19%. The increase is split roughly in half between premiums and deductibles, KFF found.

Long-term care costs also have accelerated faster than general inflation—at least, until the recent spike in consumer prices. The Genworth Cost of Care Survey shows that, from 2004 to 2021, the cost of assisted living facilities rose 4.17 percent per year, while the Social Security COLA (which reflects general inflation) rose 2.2 percent annually.

Should You Change Your Retirement Plan Assumptions About Inflation?

Despite the current high-inflation environment, there’s little reason to dramatically change the long-term assumptions about inflation that drive your retirement plan.

JPMorgan notes that annual inflation averaged 2.7% from 1982 to 2020, and then it ran at a 7.1% pace in 2021. It’s quite possible that figure will be even higher this year. For example, the Senior Citizens League forecasts that this year’s COLA could be 8.6% if current inflation trends persist for the rest of the year.

But the biggest spikes last year were in just two categories, JPMorgan notes:

  • Transportation cost increases averaged 2% from 1982 to 2020 but jumped 21.4% in 2021.
  • Food and beverage costs jumped from a 2.7% long-term rate to 6.0% last year.

Those trends are not likely to persist over the long haul. Indeed, JPMorgan suggests sticking with a moderate inflation assumption of 2%-3% for your overall plan—but make a separate set of assumptions for healthcare and long-term care.

“It makes sense to plan for healthcare costs at 5.5% or 6%,” Carson says. “Medicare costs are rising more quickly, and you do need to plan for long-term care. But the rest of your expenses may not grow that quickly.”

Mark Miller is a journalist and author who writes about trends in retirement and aging. He is a columnist for Reuters and also contributes to The New York Times and WealthManagement.com. He publishes a weekly newsletter on news and trends in the field at RetirementRevised. The views expressed in this column do not necessarily reflect the views of Morningstar.


Clarification
The sentence "The spending power of $100—assuming an inflation rate of 2%—would be just $164 at the end of a 25-year retirement." Was changed to "One hundred dollars—assuming an inflation rate of 2%—would have the same purchasing power as $164 after 25 years."