Inflation and Debt in Retirement Planning


By Henry K. Hebeler



There are a lot of things that can ruin a retireeís future plans, but none so stealthy as inflation. During the first ten years of my retirement, inflation claimed 30% of the purchasing power of my fixed income pension. That was in a time when some people were saying we had no inflation. Then there was the retirement of my father. Between the ages of 65 and 96, inflation took 80% of his income. Prices had gone up five times during that span. People often forget that inflation compounds, just like investments.

No one can accurately predict what the inflation will be next year nor even get close to what it may be over a decade or more in the future. Largely, professional planners rely on historical values and assume that inflation will revert to an historical compound rate. Then the question becomes which period of time one should use to establish the rate. The common historical value of about 3% includes the effects of the great depression which had a number of years of negative inflation. Starting a bit later, the historical value averages over 4%. Generally, if you want to have a conservative retirement plan, you would use a value on the high end and pray that you wonít see rates like in the Ď70s and early Ď80s when inflation rates sometimes tripled or even quadrupled.

I maintain that retirees have higher inflation rates than the populationís average because they have a much higher constituency of fast escalating medical related costs including medical insurance and uninsured costs for doctors, dentists, drugs, ears, and eye care. The ultimate inflation blow comes to those who progress from their home, then to independent living to, then to assisted care, and finally to a nursing home. This alone is a good reason to make a long-range retirement projection using a conservative (high) inflation rate.

Donít think that mortgage payments reduce your personal inflation rate.

I have a friend who early in his retirement said his actual inflation was very low because his largest expense was his mortgage payments on his house, and those payments had no inflation. Now that heís paid off his house, he feels differently as his medical insurance and uninsured medical costs have soared.

Actually my friend had relatively high inflation all along. He should have looked at his house debt as a negative investment. Instead of getting interest payments, he made interest payments. If you use a comprehensive retirement program that asks for a debt input, or alternatively interest and debt details, then the program is looking at debt as a negative investment. Effectively, the program is subtracting debt from investments.

When retirement planning programs ask for debt information, almost always you get an output that tells how much you can spend this year that excludes the debt payments. Consider this example: Suppose you were retired and had $300,000 investments and $100,000 mortgage. If your life expectancy was 25 years and your return on investments less inflation was 2%, then the amount you could spend from $300,000 would be $15,366 a year plus an annual inflation adjustment according to common financial planning projections. A program that subtracts debt from investments would say you could spend on $10,244 annually. The latter value excludes the debt payments because, in effect, it assumes you had made the decision to pay off the debt with $100,000 of your investments.

Itís unlikely that your actual debt payment would be the difference between $15,366 and $10,244 because the actual payment depends on your interest rate and number of years left on the mortgage payments. In general, if the mortgage payments will end in a period that is short compared to your remaining life-expectancy, then the mortgage payments will be much larger than the $5,122 difference. Thatís because the retirement program, in effect, assumes that you really wonít pay off the last of the debt until the day you die. There is nothing wrong with this machination, because the amount that you can really afford to spend is $10,244 plus the fixed mortgage paymentsóor even $10,244 plus the whole debt if you choose to pay it off instantly. After you have paid the mortgage, the amount you can spend is still $10,244 (adjusted for inflation) in this theoretical world of the computer. If you used one of the overly simplified planning programs that did not ask for debt information, you would have a sudden jump in what you could pay for things other than the mortgage after you made the last debt payment.

I went through this example to show that my friendís inflation was not really ameliorated at all by the fact that a large part of his cash outflows were fixed. The $10,244 would continue to increase with whatever was the assumed inflation rate until the end of the 25 year life-expectancy. When my friend entered an inflation rate in the computer, it should have been an inflation rate that corresponded to the $10,244, not a lower inflation rate that corresponded to the fact that a large part of his outflows were inflation proof. This is a really hard point for most retirees to grasp. It all comes back to remembering that debt is a negative investment in such retirement programs.

Four planning suggestions related to inflation:

I believe that itís wise to do all of the four things below, even though there may be some overlap.

(1) Do not be optimistic about inflation.

Use whatever you think may be a conservative (high) inflation rate in the basic planning equations. This will be of particular importance if inflation takes off in a very general way as a consequence of the huge personal, state, federal and international debts or from other factors. No one knows how all these things will turn out, so no one really knows what will happen to future inflation rates. If you make conservative assumptions you will protect yourself from higher inflation, and if inflation is low, you may have a little extra to help compensate for adversities from all of those other unknowns including returns on investments, taxes, life-expectancy, and unforeseen family problems or unplanned events.

(2) Adjust Social Security for likely long-term degradation.

Social Security increases correspond to the inflation rate of a basket of goods and services that doesnít have the higher medical component thatís appropriate for the elderly. In fact, the Social Security payments donít increase even as fast as normal inflation because Medicare Part B is deducted from the checks. These costs have been increasing at roughly 8% a year, so the actual net take-home pay grows significantly less than the inflation index. Ultimately, there may be larger effects on Social Security payments as the inflation index gets redefined for political reasons to reduce the governmentís future obligations and/or the tax exemptions for Social Security disappear.

The government has a lot to gain from understating inflation. For example, over twenty five years, only a 1% shortfall of Social Security is equivalent to 2.6 years of Social Security disbursements in todayís dollar values. Thatís billions of dollars saved from the governmentís standpoint but an out-of-pocket cost for the elderly.

I think that itís wise to assume that even the gross Social Security will not increase as much as it should if you are a prospective or young retiree and expect to see part of the current quotes be legislated or taxed away. There is a simple formula for doing this when employing a forecasting method that does not let you enter a lower inflation rate for the Social Security annual adjustment. Simply reduce your Social Security quote by an amount equal to your quote times 0.4 times your life-expectancy in retirement times the percent of inflation shortfall. For example, if your Social Security quote was $1,000 a month, your life-expectancy in retirement was 25 years, and you thought Social Security would increase by only 3% when your actual inflation would be 4%, reduce your Social Security input by $1,000 x 0.4 x 25 x (4% - 3%) = $100. In this example, enter $900, not $1,000 a month, in the computer program.

(3) Budget for high inflation rate items:

There is part of your income that goes to high inflation rate items which are likely to include medical, dental, and utility costs. Letís say that your retirement planning program said you could budget $40,000 (annual after-tax) assuming 3% increase each year until you die. Further suppose that right now $10,000 of that goes to high inflation rate items that might escalate at 5% when the average inflation rate was 3%. In order to compensate for the high inflation rate, you are going to have to save part of the remaining $30,000 so that you have some investments you can draw down later to help pay for the undue escalation of the $10,000 items.

The amount that you have to save is the high costs items times 0.5 times life-expectancy times the extra amount of inflation. In this example, that would be $10,000 x 0.5 x 25 x (5% - 3%) = $2,500. Therefore, instead of spending $30,000 for the lower-inflation items, you would spend only $27,500. That would leave $2,500 in your investments to grow and help offset the future growth of high-inflation items. Each subsequent year you would use the same equation with a lower life-expectancy, and in each of those years the retirement planning program would forecast a new budget consistent with the increased investment levels that came from these savings.

4. Save some of your fixed payment pensions or annuities:

There are many retired people who just spend whatever after-tax income that they get from Social Security, IRA required minimum distributions, and pension. Actually, most people should be saving a little of their Social Security as described above. On the other hand, the new rules on required minimum distributions are conservative, so there is no problem using all of the after-tax receipts from those minimum distributions. However, there is a big problem with spending the entire after-tax amount from a fixed pension or from fixed payment annuities.

Technically, the most you should spend from a fixed pension is the after-tax amount multiplied by Pmt(Real Return, Life-Expectancy, PV = -1) divided by Pmt(Actual Return, Life-Expectancy, PV = -1), but few people have a financial calculator that can come up with those results. Iíve come up with what I call Hebelerís fixed pension formula which is simply to multiply the after-tax value of the pension time your age divided by 100. For example, if you were getting $1,000 a month after-tax at age 65, you would only spend $1,000 x 65 / 100 = $650. You would have to save $350 which would gradually be withdrawn in future years to compensate for moderate amounts of inflation providing that you could invest and get an after-tax return that was slightly higher than inflation.

Those who are using one of those simplified computer programs that does not ask whether your pension has a cost-of-living-adjustment (COLA), are likely to be misled, because most of those people who write those simple programs assume that all pensions have a COLA. In fact, only a few pensions have a COLA. If you are not yet retired, and do not have a COLA, and the program doesnít ask whether your employerís pension quote is in todayís dollars or the actual value at retirement, then you should know there is another potential problem. You can tell whether there is a problem if your employerís pension quote is based on some amount of wage growth until retirement. In that situation, the best thing is to go to a program that accounts for this as do those on If you are just doing a back-of-the-envelope analysis in this situation, use Hebelerís fixed pension formula even if you arenít retired.


Retirees are likely to have higher inflation rates that the population as a whole due to needing an ever increasing proportion of medical insurance and uninsured medical costs. Further, drug, dental, eye, ear care, and support costs are big items for the elderly and are likely to continue their abnormally high escalation.

Donít believe that you should use a low inflation rate in a retirement planning program because a large part of your cash outflows go to fixed mortgage payments. Any retirement program that asks for debt information effectively considers debt as a negative investment, and the majority of those programs give you an annual budget that excludes debt payments. In such cases you can add your actual debt payments to the calculated budget. The program is assuming that investments are offsetting the debt, and expenses (excluding debt payments) are increasing at your specified inflation rate.

There are four things you can do to better plan for higher inflation:

(1) Use a conservative (high) rate in the planning equations or computer program input. Donít assume that inflation rates will remain low because the government or investment firms tell you so. They donít know any better than you what will happen in the future, and some conservatism here will help offset all of those other planning unknowns such as returns, tax rates, life-expectancy, unforeseen events, etc.

(2) Social Security payments are likely to be less generous in the long-term future, so itís wise to plan on less than full inflation increases. Some computer programs let you account for this. If not, there is a simple formula above that will help.

(3) When you get a bottom-line budget from a retirement planning program, you will have to proportion that among normal and high inflation rate items. This really amounts to having to share the normal inflation budget items with a savings element to compensate for the extraordinary growth of the high-inflation items. There is a formula to help with this in the text above as well.

(4) If you are retired, do not plan on spending more than the after-tax amount of a fixed pension or fixed payment annuity multiplied times your age over 100. If you are not retired and making a forecast with a computer program, make sure that you use a program that asks whether the pension has a COLA and whether the pension quote is in todayís dollar values or is the projected amount you will actually get when retiring.

You canít wish that inflation will go away or pretend that it doesnít exist. Itís the stealth component of economic planning that destroys fixed income and raises prices to unimagined levels during your lifetime. The earlier you face up to inflationís realities, the better you will fare in the long-run.