Investing in a 401(k) is a common path to building retirement wealth while enjoying some tax advantages. When inflation is on the rise, the future purchasing power of 401(k) assets can shrink. Accounting for the effects of increasing prices in a retirement savings strategy is important for ensuring that your money will go as far as you need it to.
Key Takeaways
- A 401(k) plan is a tax-advantaged retirement plan that can be funded with employer and employee contributions.
- Inflation is characterized by an extended period of rising consumer prices for goods and services.
- When inflation exceeds a 401(k)'s rate of return, the portfolio's purchasing power decreases.
- This means the individual will technically be able to purchase less items than before, as the increase in return did not make up for the increase in cost of living expenses.
- Building inflationary hedges into your 401(k) investment and savings strategy can help you to minimize some of the negative impacts of rising prices.
What Is Inflation?
Inflation is a general upward trend in the movement of prices for consumer goods and services. In the U.S., inflation is measured by the Consumer Price Index (CPI). The CPI measures the average prices paid by consumers for specific categories of goods and services, including food, fuel, and energy.
The Federal Reserve aims for a target inflation rate of 2% or less for any given 12-month period. This threshold is deemed as being ideal for maintaining employment and price stability. Most recently, inflation peaked at 9.1% for the year ending June 2022, while the CPI was up 6.4% from a year ago as of January 2023.
Important
When inflation is accompanied by flatlining economic growth and high unemployment, that can lead to a poor economic condition called stagflation.
How Inflation Affects 401(k) Retirement Savings
Inflation impacts purchasing power. When prices are higher, it costs more money to buy the same things. From a retirement savings perspective, that's problematic, as stocks and other investments do not automatically adjust for inflation. What this means is that extended periods of inflation can erode your 401(k) returns.
So, for example, if inflation rises to 8.5% and your 401(k) investments return 9%, your net gain actually works out to 0.5%. Although your portfolio's return may seem impressive, you ended up barely keeping pace with rising costs as your retirement fund will now only minimally surpass what you could have previously afforded.
If your 401(k) returns 7%, on the other hand, your net gain ends up in the negative. Typically, financial advisors and experts aim for a return of 5% to 8% from 401(k) investments. The by comparison, posits a historical return of around 10%, which drops to approximately 7% when adjusted for inflation.
Rising inflation means your investments have to work harder to keep pace. How much of a pinch you feel in your 401(k) can depend on how close you are to retirement and what type of investing strategy you're pursuing.
Note
While inflation can negatively impact 401(k) returns, it can take an even bigger bite out of savings, money market, and CD accounts that earn comparatively lower rates of interest.
Protecting Your 401(k) Against Inflation
Inflation is often driven by a variety of complex factors, most of which the average consumer has no control over. There are, however, some things you can do to insulate your 401(k) retirement savings against the most damaging impacts of inflation.
Maintain (or Increase) Contributions
When prices are rising and your paychecks don't go as far, it's tempting to pull back on contributions to 401(k) plans or other retirement accounts. It's still important to contribute at least enough to get the full company match if one is offered so that your money can continue to grow.
If possible, you may even consider raising your contribution rate so that more of your money is going into your plan. Remember, for 2022 you can contribute up to $20,500 to your 401(k), with a $6,500 catch-up contribution allowed if you're 50 or older. In 2023, you can contribute up to $22,500 into your 401(k) with a $7,500 catch-up contribution for qualifying individuals.
Diversify Plan Investments
Diversification simply means spreading your investment dollars across different types of assets in order to minimize risk. During periods of higher prices, diversification can also help with minimizing inflationary impacts on your 401(k).
For example, you may choose to allocate more of your investments to mutual funds holding stocks that rise with inflation. Short-term bonds can also be a safer bet when inflation is higher since you're not locked in to lower rates for an extended period. You may also consider funds that hold commodities or real estate, both of which can perform well amid higher inflation.
If you have money saved in target-date funds (TDFs) in your 401(k), consider whether the fund's glide path will deliver the kind of returns you need to keep up with inflation.
Check Investment Fees
Minimizing investment fees can be a good move at any time, but especially so when inflation threatens to shrink your 401(k) returns. The less you pay in fees, the more of your returns you get to keep over the long term. When reviewing 401(k) plan fees, consider what you're paying in expense ratios for individual funds you hold. For perspective, in 2021, the average equity mutual fund expense ratio was 0.47%, while the average bond fund expense ratio is 0.39%.
Does a 401(k) Beat Inflation?
Investments in a 401(k) plan are not adjusted for inflation automatically. Whether your plan can beat inflation or not depends on the level of returns you earn each year and how the inflation rate moves up or down over time. Ideally, inflation remains at 2% or less annually while 401(k) returns are in the 5% to 8% range, allowing your savings to outpace rising prices.
How Does a 401(k) Protect From Inflation?
Continuing to invest in a 401(k) during periods of higher inflation can offer some protection if you hold investments that move in tandem with rising prices. Stocks, for example, can deliver much higher returns to investors than money market accounts, savings accounts, or CD accounts, offering some insulation against the effects of inflation.
What Should I Do With My 401(k) With Inflation?
When inflation is picking up speed, some of the best things you can do with your 401(k) include maintaining your contribution rate (or increasing it, if possible), diversifying your investments, and finding ways to minimize fees. You can also supplement 401(k) savings with investments in an individual retirement account (IRA) and/or a taxable brokerage account.
How Much Does a 401(k) Go Up Each Year?
The increase an investor sees in their 401(k) each year depends on what they've invested in and how the market in general performs. A typical rate of return for a 401(k) plan is 5% to 8%, though it's possible to see returns above or below those thresholds. Tracking your 401(k) returns year over year and the performance of individual funds within the plan can help you fine-tune your investment strategy.
The Bottom Line
Investing in a 401(k) can be one of the best ways to build wealth over time, particularly if you're able to max out your plan and get the full employer matching contribution. While inflation can be a threat to your retirement savings, there are ways to soften the blow that rising prices may deliver to a 401(k). Keep in mind that a 401(k) isn't your only option for saving, either. If you want to create a comprehensive savings strategy, you may also consider shopping around for an individual retirement account (IRA) or an online brokerage account to grow your portfolio.
As an expert in personal finance and retirement planning, I bring a wealth of knowledge to shed light on the intricacies of investing in a 401(k) and navigating the challenges posed by inflation. My expertise is rooted in a deep understanding of financial markets, investment strategies, and the broader economic landscape.
Let's delve into the concepts presented in the article and provide additional insights:
1. 401(k) Overview:
- A 401(k) plan is a tax-advantaged retirement plan funded by both employer and employee contributions.
- It offers significant tax advantages, making it a common vehicle for building retirement wealth.
2. Inflation and its Impact:
- Inflation is a general increase in prices for consumer goods and services over time.
- In the U.S., the Consumer Price Index (CPI) is used to measure inflation.
- The Federal Reserve targets an inflation rate of 2% or less for economic stability.
- Inflation erodes the purchasing power of 401(k) assets, impacting the real value of savings.
3. How Inflation Affects 401(k) Returns:
- When inflation surpasses a 401(k)'s rate of return, the portfolio's purchasing power decreases.
- Extended periods of inflation can erode 401(k) returns, impacting the ability to afford the same goods and services.
4. Protecting Your 401(k) Against Inflation:
- Maintain or increase contributions during inflationary periods.
- Diversify investments to minimize risk, considering stocks, short-term bonds, commodities, or real estate.
- Check and minimize investment fees to maximize long-term returns.
5. 401(k) and Inflation Interaction:
- 401(k) investments are not automatically adjusted for inflation.
- The ability of a 401(k) to beat inflation depends on annual returns and inflation rate movements.
- Stocks in a 401(k) can provide higher returns than conservative options, acting as a hedge against inflation.
6. Strategies During Inflation:
- Continuing to invest in a 401(k) during inflation can provide protection if investments align with rising prices.
- Consider maintaining or increasing contributions, diversifying investments, and minimizing fees.
- Supplementing 401(k) savings with an IRA or taxable brokerage account is advisable.
7. 401(k) Growth and Monitoring:
- Annual 401(k) growth varies based on market performance and investment choices.
- Tracking returns and fund performance helps fine-tune investment strategies.
8. The Bottom Line:
- Investing in a 401(k) is a powerful wealth-building strategy, especially with employer matching contributions.
- Inflation poses a threat, but strategic measures such as diversification and contribution adjustments can mitigate its impact.
- Exploring alternative savings options like IRAs or online brokerage accounts enhances a comprehensive savings strategy.
In conclusion, a well-informed approach to managing a 401(k) in the face of inflation involves a combination of strategic investment choices, vigilant monitoring, and a proactive response to economic conditions.
