(The News Tribune) - Inflation erodes the value of your money and encourages you to find ways to invest that could be expected to outpace inflation over time. You likely see inflation in your grocery bills and other expenses that are essential in your monthly budget.
This is evident here and now but doesn’t well represent the impact on your long-term financial security. Much attention has been paid to inflation over the past several months as year-over-year increases have been the largest in 40 years. While there are some signs that inflation has peaked, it won’t revert quickly to the U.S. Federal Reserve’s target of 2 percent average annual cost of living increases.
Recently, some prominent investment managers have communicated that they think the United States, particularly, but also much of the world, has entered a new era of persistently higher inflation. They believe the 2 percent inflation target would be difficult to achieve. To demonstrate the effects of higher inflation on long-term financial security, consider a simple example using a financial planning program to evaluate the probability that you could sustain withdrawals from your investments throughout retirement.
The hypothetical investor retired this summer on their 65th birthday. They expect to live to 90 and have a $1 million investment balance. We assume a balanced portfolio of 60 percent stocks and 40 percent bonds with an expected long-term average annual return of 6 percent. The investor desires annual withdrawals of 4 percent of the account balance ($40,000 in year one) and increases this withdrawal each year, adjusting for inflation.
From 2002 through 2021, average annual inflation in the United States was 2.15 percent. Using this level of inflation in the hypothetical scenario, the financial planning program projects an 89 percent probability of success that the $40,000 per year (with annual cost of living adjustment) could be sustained for 25 years. That is a strong probability of success.
There is no need for the probability to be 100 percent. That would just mean you had more capacity to spend and chose not to. In this case, even after 25 years of withdrawals, the median projected ending wealth is $886,300 (in today’s dollars). That provides a helpful margin of safety in case longevity stretches life past 90 or in case expenses turn out to be higher than planned.
But at what point does higher inflation sap confidence in retirement income security? Leaving all the other inputs constant but increasing inflation from 2.15 percent to 3 percent per year for life, the probability of success sustaining the annual withdrawals declines to 82 percent and the margin of safety of median dollars left over at the end is $558,887.
This is a roughly $330,000 decline but still represents meaningful financial security. Bump the inflation factor to 4 percent annually and the sustainability of the lifetime income stream weakens considerably. The probability of funding the desired annual withdrawal from the investment account dips to 71 percent with just $289,372 dollars remaining at age 90.
This would suggest that as long as inflation averages less than 4 percent going forward (possibly meaning it stays above 4 percent for the next couple of years but then declines below), the impact on financial security might be manageable for many people. Of course, this assumes the long-term expected investment returns are also realized.
This example does not consider the impact of income taxes or the likelihood that other income is available from Social Security, which includes an annual cost-of-living adjustment.
Retirement income planning always has many other important factors to consider.
Spending for many retirees lessens over time. Expenses are likely higher in the first several years of more active retirement but generally decline. Reducing spending is one way to combat inflation, as you have less need to keep up with growing expenses.
If inflation and interest rates persist at higher levels, you might be justified in also expecting a higher investment return, helping to offset the higher inflation. It might be reasonable for the 6 percent annual return referenced earlier for the 60 percent stocks portfolio to become 6.5 percent. Conservative investors, however, might not be positioned for enough return to offset inflation, which is a risk for them, just as more volatility in account balances is a risk for a more aggressive investor.
While many retirees assume they need to lean more toward bonds in their investment strategy as they age, persistent inflation could turn that rule of thumb upside down. In many cases, it might be preferred to increase the weight of stocks.
Understanding the bite that Inflation could take out of your retirement savings could be critical to your lifetime income security. Hopefully, that bite is not so large that you run out of money before you run out of time.
By Gary Brooks
September 5, 2022
