Inflation is something spoken about often, but did you know it can play a significant role in your financial planning?
If you didn’t know, inflation is the process of any currency’s purchasing power depleting over time. One common symptom of this is when prices of goods and services rise, and the amount that one can purchase grows smaller.
Another term, though less common, is inflation’s counterpart, deflation. Deflation occurs when the price of goods and services falls, and there is more purchasing power for the same amount of money.
Why does inflation happen?
Inflation occurs naturally throughout the years and can be a sign of a healthy economy. For the most part, we can expect a steady rate of inflation throughout our lives. In America, the rate of inflation is typically just over 3% year-to-year, and inflation is considered healthy for economic growth.
Sometimes it may be because there is more money in circulation than needed. Other times, it can be a result of world events that completely alter a market, leading to astronomical or atypical inflation, such as following World War II.
What Inflation Looks Like
Inflation is the difference in what $1 might buy you in 2000 versus what it could buy you in 2020. As prices of services and goods have steadily risen over time, the value of a dollar has fallen, meaning that the same $1 will afford you fewer goods than it did in 2000.
Inflation’s Effect on Your Assets
Inflation isn’t always so simple, though, and it’s not always negative. Sometimes, it can affect the money you don’t see every day, such as your investments and financial planning. Let’s look at life insurance policies for an example of a good and bad inflation outcome.
When it comes to life insurance, there are two main types, whole or term policies. A term policy will last a certain amount of years, such as 10 to 30, and the life insurance quotes for this are generally more affordable upfront. On the other hand, a whole policy will be pricier month-to-month, but cover your entire life, whether it be ten, twenty, or seventy years. Inflation will affect both of these policy types differently.
How Inflation Affects Term vs. Whole Life Insurance Policies
When it comes to term life insurance, your death benefit loses some of its value over time because the value of a dollar depletes every day with natural inflation. This means that if you pass away in twenty years, the policy paid out will have less purchasing power than the value you originally purchased it for. To simplify it further, a $1,000,000 policy purchased today could have the purchasing power of only $500,000 after, say, twenty years, due to inflation.
The impact of this is often offset by natural life trends in the buyer’s life — for example, if you buy life insurance to cover your spouse to live until retirement, they will have far fewer years to rely on a death benefit 30 years from now than they would tomorrow.
In the case of whole policies, the policy is not as affected by inflation because they usually include interest and in some cases dividends, which means a $1,000,000 policy could grow by the time of your death. These numbers will make up for and usually outpace natural inflation over the course of many years. However, the premium cost is much higher for whole policies, which renders them inaccessible for many Americans, or simply not the best use of their money.
It’s important to compare your long-term goals with your current financial standings to make the most informed decisions. If you’re new to life insurance and familiarizing yourself with whether a term or whole policy is best, it may be helpful to check out an inflation calculator or speak with a specialist to decide what’s right for your unique situation.