Final answer:
Inflation is an increase in prices that can erode the value of money saved for retirement. Those with fixed incomes, such as retirees on defined benefits plans, are at risk of losing purchasing power over time due to inflation. This can result in a substantial reduction in their standard of living as the cost of living rises while their income does not.
Step-by-step explanation:
Inflation is the general increase in prices and fall in the purchasing value of money.
For someone with a retirement plan that consists of saving a fixed sum of money, such as putting $100 into a safe, inflation can erode the purchasing power of these saved funds over time.
This is especially pertinent for those with a fixed income, such as retirees on a private company pension set as a fixed nominal dollar amount per year.
These individuals are particularly vulnerable as their income does not typically increase with inflation. This can lead to significant losses in their standard of living as the cost of living increases, but their income remains static.
Consider a retiree who has a defined benefits plan and places their trust in a fixed retirement savings without adjustment for inflation.
If they retire at age 65 with a fixed income, even a slight annual inflation rate of 1% to 2% will considerably reduce their buying power after a decade or two.
The effect of compounding yearly inflation rates means that the individual's saved funds will buy less and less as time goes on.