Road to Retirement: Inflation can ruin a well-planned retirement

If you consider all the different threats to your retirement security, inflation is the hardest to handle. Just for fun, let’s take a look at how quickly inflation can destroy a nice nest egg. Then let’s consider what can be done about it.

Let’s assume you retire with $1 million and want to take a 4% inflation-adjusted distribution from your portfolio (4% is the general default rate for retirement planning). That means in the first year, you’d take $40,000 and increase that amount every year by the inflation rate. Let’s now assume inflation runs at 4% a year, which is half of its current rate of about 8%.

If you put your money in a savings account and roughly earned zero, which is about the going rate these days, you’d be out of money in 17 years. The reason is your distribution starts at $40,000 per year, and with 4% inflation, rises to $75,000 by year 17, or a distribution rate of about 7.5% per year.

If you want a chance of maintaining your principal balance at $1 million throughout your retirement and distributing 4%, you’d need a return of about 6.75%. You might think 6.75% shouldn’t be too hard. But with interest rates stuck around 2.3%, on a typical 60% stock / 40% bond portfolio, you’d need stock returns of about 10% for the next 30 years. Consider that since the year 2000, the annualized total return for the S&P 500 is only 7.2%.  And that was during a period of sizeable support for markets from the federal government.

Going forward, it’s not looking like we’ll have as much of a tailwind. Inflation is way above any manageable level, interest rates are rising, and Fed support for financial markets is waning. The factors that supported the markets are now being put into reverse, so one should expect it will be a tougher row to hoe. The bottom line is that if inflation runs hot, the typical balanced portfolio between stocks and bonds is less likely to produce the returns you need going forward.

So, if investors need higher returns, how do they get them? Maybe you could do a better job picking stocks and bonds and “beat” the market. Maybe, but it’s unlikely. And even if you did, the return difference over 30 years is likely to be measured in fractions of a percentage.

It’s like the 100-meter dash at the Olympics. Everyone in the race is world class, and the winner is just barely ahead of the overall field. That’s how the financial markets work. It’s full of world-class competitors, and the winners are just barely ahead of the rest of the field. Thus, I wouldn’t bank on better performance making the difference. If returns are low and inflation is high going forward, it’s going to be tough for all of us.

The next question is: if you can’t do much about the returns side, what should you do? Well, you have to look at the expense side. Inflation is a number that gives us a rough read on how prices are rising across the economy. But your personal inflation rate might be very different. This is the side of the equation where you can have the most impact.

For instance, if you own your home and it’s paid off, then housing inflation doesn’t impact you much. If car prices are rising, you can keep your car longer, or next time you buy one, skip the premium features and go with a basic model. If it costs more to go on a vacation, you can do something less elaborate. The list of potential budget adjustments is long, and each person has to decide what’s important for their lifestyle. But consider that if inflation runs 4%, and your personal inflation rate is only 2%, then you are back to a low inflation environment, and retirement gets a lot easier.

Right now, the highest probability bet is to focus on what you can control, which is to lower your personal inflation rate.  Then let’s see how markets do. The economy is surprisingly resilient, so the returns might be there eventually, or maybe inflation fades away. But just in case we face structurally higher inflation, work on getting your expenses as low as possible.

Charlie Farrell is a partner and managing director at Beacon Pointe Advisors LLC. The information contained in this article is for general informational purposes only. Opinions referenced are as of the publication date and may be modified because of changes in the market or economic conditions and may not necessarily come to pass. All investments involve risks, including the loss of principal.

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