Inflation is the rise in prices over time, with the result that a dollar will buy fewer and fewer goods and services—your purchasing power decreases. Even low inflation is a "silent thief," and is especially threatening to the security of those who rely on fixed incomes, as many retired folks do. For example, just 2% inflation—an unrealistically low long-term assumption—means that something that costs $1.00 today would cost $1.22 in 10 years. Inflation risk is the risk that this process will eventually have a negative impact on your standard of living.
The Effects of Inflation Risk
This impact can take one or more forms. For some, it might simply be that small luxuries can no longer be enjoyed. For others, the loss of purchasing power can mean hard choices regarding the necessities of life, such as food, medical care, gasoline, and home heating. Indeed, during difficult times, many find it necessary to move in with family or downsize to a smaller residence
Dealing with the Risk
Retirees might find it necessary to return to the workforce, at least part time. They are particularly vulnerable to inflation risk because retirees tend to rely more on streams of income, such as dividends and interest, that are not adjusted for inflation. Moreover, since they are older, they can rely less on long-term growth investments that younger people might favor. Finally, the government estimates that inflation in the cost of goods and services purchased by older people tends to be greater than the general, economy-wide rate of inflation. Sound retirement planning therefore requires that the effect of inflation be taken into account. This might mean you'll need to put more of your nest egg into growth oriented—riskier—investments than you might have initially felt comfortable with, keeping in mind that there is inflation risk in just "playing it safe." Note that Social Security benefits are subject to annual cost-of-living adjustments. That's helpful, but most people cannot survive on Social Security alone in any event, so this is not a viable solution to inflation risk.
Managing Inflation Risk
Inflation risk can be managed in several ways, including decreasing living expenses, altering your income streams, or changing your investments. But the sooner inflation risk is taken into account, the more flexibility you will have in preparing for it. For example, you can look into inflation-adjusted annuities. U.S. inflation-adjusted bonds, called "TIPS" (Treasury inflation-protected securities) are another popular option. These products provide monthly income that is adjusted annually for inflation.