With inflation still high, which is best for your long-term retirement strategy?
What is Inflation?
Inflation is an increase in the general level of prices for goods and services. Deflation, on the other hand, is a decrease in prices for goods and services. If inflation is high, at say, 10% – as in the 1970s – then a loaf of bread that costs $1 this year will cost $1.10 next year.
Historically, inflation in the US averaged 3.3% between 1914 and 2022, but it reached an all-time high of 23.7% in June 1920 and a record low of -15.8% in June 1921. Currently, the inflation rate in the US is stubbornly high. In February 2023, the Consumer Price Index for All Consumers increased by 0.4 percent, seasonally adjusted, and rose 6.0 percent over the last 12 months.
So how does inflation affect your retirement savings? The answer is simple: inflation decreases the purchasing power of your money in the future. Consider this: at 3% inflation, $100 today will be worth $67.30 in 20 years – a loss of 1/3 its value. That $100 will only buy you $67.30 worth of goods and services in 20 years. And in 35 years? Well, your $100 will be worth just $34.44.
A certificate of deposit – a CD – is what’s known as a time deposit account – a bank agrees to pay interest at a fixed rate if savers deposit their cash for a fixed period of time. The Federal Deposit Insurance Corporation (FDIC) insures banks’ CDs, and the National Credit Union Administration (NCUA) for credit unions.
As the chart below shows, CD yields have been in a steady decline for the past four decades:
Nearly 40 years ago, certificates of deposit were considered excellent investments, with the average annual percentage yield on a one-year CD over 11%. But today, although average rates on CDs are starting to climb as the Fed has raised rates, 12-month savings rates are just reaching 5% after nearly a decade of rates below 1%.
One-Year CD Vs. Five-Year CD
Generally speaking, the bank’s interest rate increases as the term (the time the bank has your money) increases. We’re currently seeing an inverted yield curve, where short-term rates (1-year and less) are higher than long-term rates (5+ year CDs). This is due to the rapid increase in the Federal Reserve’s benchmark interest rate, which is currently at 4.75-5.00%, up from a historic low of 0.25% in late 2008. Longer-term interest rates are less affected by changes in the benchmark rate and more by the long-term expected inflation rate. Thus, there is less of an incentive for banks to offer higher yields on long-term CDs.
CD investors find themselves in a difficult position as the Federal Reserve continues increasing interest rates. Although higher interest rates should mean more money for investors, the fact of the matter is that short-term CD rates have not kept pace with inflation. And long-term rates are staying low, expecting a return of lower inflation rates.
Federal Funds Rate
It’s important to note that the federal funds rate, which is set by the Federal Reserve Bank and generally closely followed by banks and credit unions, has a tremendous influence on short-term interest rates. A higher federal funds rate means higher rates on certificates of deposit, making them more attractive investments.
When the Fed raises its target for this benchmark interest rate, many financial institutions raise the interest rates they offer on CDs, making them a more attractive option than keeping your money in cash. But fed rate hikes typically occur after inflation has already started or, in recent cases, peaked. That means the CD rate increases will lag inflation increases and decrease future purchasing power.
The Stock Market
If you are looking for average stock market returns over a long period of time, you are likely to get different numbers from different sources. That is because your answer depends on many variables, including which index you review, if dividends are reinvested, whether the effects of inflation are calculated, etc.
However, most financial professionals agree that the long-term data for the stock market points to an average annual return of about 10%. The S&P 500 has returned a historic annualized average return of 10.67% from its 1957 inception through 2022.
But it’s essential to understand the impact that inflation has on the stock market, too – in other words, know that inflation-adjusted returns on the stock market are typically 3-4 percentage points lower than the long-term averages.
|Average Rate of Return||Inflation-Adjusted Return|
The Mattress and Shoebox
Surprisingly, some people prefer to keep their savings under a mattress or in a shoebox hidden away in a closet.
But here are the Average Annual Returns for every investor who hid their money under a mattress or in a shoebox:
What Investors Need to Remember
Although there are times when buying a CD might be appropriate, generally speaking, buying CDs should not be a core part of your long-term retirement strategy – unless you happen to be very close to retirement age. CD rates today don’t keep pace with inflation. And putting your money under a mattress is worse (and probably uncomfortable too).
Instead, I encourage you to explore the thousands of financial products that provide better options. And remember that over long periods, the stock market has outpaced inflation, today’s CD yields, and hiding your money under your mattress or in a dark shoebox.
But before you invest in anything, consider the risk/reward tradeoff, your goals, and your time horizon – and call my office to discuss.