Inflation is a menace to your purchasing power. It destroys the value of your money.
You can use the rule of 72 to figure out how long it will take for an investment to double when the annual rate of return is known. If you invest $1,000 and want it to double at an 8% return, calculate 72/8 = 9. In this example, it would take approximately 9 years for your $1,000 to double.
The same rule can be applied to inflation. From 1913 to 2013, the average annual inflation has been 3.22%. To conservative, let’s round up. 4% inflation divided into 72 is 18 years. This means that if you’re retiring at age 65, you will have to double your income by age 83 to maintain your current standard of living.
This is pretty scary. Of course the stock market’s long-term return beats inflation, but when you’re approaching retirement age, you want to dial down your risk. Bonds are safer than stocks, but bonds get killed by inflation.
The U.S. Treasury offers a specific type of bond that will protect you from losing your buying power well into retirement. It’s called the I-bond.
I-bonds have two parts. The first part is the fixed rate that’s in effect when you purchase the bond. If this rate is 1%, this is the amount you will receive on top of inflation and it will stay the same for the life of the bond. The second part is the variable inflation-adjustment rate that’s recalculated twice a year. This rate is based on inflation and measured by the Consumer Price Index. If your real rate on the bond is 1% and inflation is 3%, you’ll earn 4% on the bond. Since the Treasury adds the inflation rate on top of the fixed rate, your before-tax return will be higher than inflation.
I-bonds haven’t been much of a fighter recently, because the Treasury set their fixed rate to zero. However, your purchasing power will still be protected, ensuring that your standard of living won’t have to be cut in half in your eighties. The only drawback is that you’re taxed on both the fixed rate and the inflation rate of your yield, meaning that if you’re in a higher tax bracket you may end up with less purchasing power. This is why I bonds are tax-deferred for up to 30 years. You could wait until you’re retired and in a lower tax bracket.