Inflation is simply an increase in your cost of living caused by the economy. It reflects increases in the costs of goods and services you consume. Historically, over very long periods of time inflation has averaged about 3%. But there have been periods when it has exceeded 14% in the US and many times that in other countries around the world.
Inflation erodes your purchasing power in retirement. You have to pay more money to receive the same goods and services. Some of the things that have the highest rates of inflation recently are things retirees consume the most of, like health care and medicines.
When you plan for retirement, you need to plan for inflation. If you determine you need a certain amount to live on, say $70,000 a year, you need to adjust that amount for expected inflation.
A person in the US who reaches 65 years today can expect to live another 20 years on average for a male and almost 25 years for a female. At 3% inflation, in just 24 years you would need $140,000 to buy the same amount as you could buy with $70,000 when you retired. That means either the principal amount of your investments would need to double during the same period, or the return you earn would need to increase by the same amount.
If you had $1,000,000 in principal when you retired and you needed $70,000 per year to live and if inflation was running at 3%, you would need a return on your portfolio of 10% to maintain your purchasing power.
What investments are considered good inflation hedges? Over time equities, Treasury Inflation Protected Securities (TIPS), I Bonds for small investors, commodity linked notes, real estate and precious metals like gold have earned returns above the rate of inflation.
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