Boost Your Savings for Low Inflation

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The government has a good news/bad news announcement about Social Security, a reminder of the need to use sensible inflation projections in long-term savings and investment plans.

The good news is that the portion of income subject to Social Security tax will not rise in 2011. The tax, which costs 6.2% paid by the employee and 6.2% paid by the employer, will apply to the first $106,800 of income earned. In most years, this figure increases to reflect inflation.

Now for the bad news: Social Security checks will not increase either. Because inflation has been so low, the law prohibits a cost of living adjustment.

For many retirees, this will sting especially hard because there also was no COLA in 2010, for exactly the same reason, (although there was an outsized 5.8% benefit increase in 2009, due to a spike in energy prices, which quickly pulled back).

COLAs are figured by comparing the Consumer Price index for the third quarter of the year to its level in the third quarter of the last year in which there was a COLA increase. Although inflation has been running at about 1% for the past year, there was no COLA in 2009, so the comparison looks at the third quarter of 2008, and the index is essentially flat since then.

Unfortunately, many Social Security recipients face costs that rise faster than the overall inflation rate, due to health care costs and other expenses that hit older people harder. And older people who have much of their assets in safe bank savings and bonds are receiving rock-bottom yields.

Many older folks will simply have to tighten their belts. Younger people should build inflation expectations into their long-term plans. A key part of that strategy: don’t let your guard down just because inflation is low.

Over the long term, inflation averages around 3% a year, but it can fluctuate wildly. Though it is all but non-existent now, it hit double digits in the 1970s and early 1980s. It hit 4.7% after hurricane Katrina in 2006, and 5.6% during the oil spike in 2009. Periods of deflation, when prices fall across the board, are rare.

Savers and investors should employ two strategies for offsetting inflation’s long-term effects.

First, hold some assets likely to keep ahead of inflation. Over long periods, stocks tend to do that, largely because companies can raise prices to offset rising costs of labor and materials. In the 20th Century, stocks returned about 10% a year, on average, beating inflation by a wide margin.

Of course, stocks are risky. Safer holdings don’t generally beat inflation as much as stocks do, but that’s okay if your main goal is to keep your principal secure. To beat inflation with bank savings today you’ll need to lock your money up for at least four years. Certificates of deposit with 48 and 60 month maturities yield 1.4% and 1.65%, respectively, according to the BankingMyWay.com survey, edging out the 1% inflation rate.

If inflation were to rise, you could withdraw your money early and buy newer CDs, which would probably pay more. Use the shopping tool to find market beating CDs, and be sure to ask about early-withdrawal penalties before investing.

The second inflation beating strategy is to increase your annual savings rate by at least enough to match inflation. If you save $1,000 a month and inflation is 3%, you should save $1,030 a month the next year, $1,060.90 the year after that, and so on.

Because inflation is so low now, this practice may seem unnecessary. But if you continue to boost your savings when inflation is low you’ll be ahead of the game when inflation rises.

—For the best rates on loans, bank accounts and credit cards, enter your ZIP code at BankingMyWay.com.

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