It’s about time again for another post in my Ultimate Retirement Guide Series. As a refresher, the goal of this series will be to provide an in-depth answer to this question: “what do I need to do to retire?” As well as any questions that could stem from that initial question. The goal is to have this cover all of the information I’ve looked at since I started really becoming interested in retirement saving, both early or traditional. I hope to mostly focus on items that have been relevant to me in my own experience and where I am in my journey at the time of writing. Throughout, I will try to present as unbiased a position as possible, but I’m sure that I will not be perfect.
So far, we’ve laid out the following five large steps needed to retire:
- Determine when to retire.
- Determine the amount needed to retire.
- Save that amount.
- Prepare to transition from working to retirement.
Currently we’ve been working through step 2 by breaking it into the following subsections.
- The 4% rule of thumb
- Other withdrawal rates
- Other withdrawal strategies
- Length of retirement (and sequence of return risk)
- Asset Allocation
- Different types of investment strategies (rentals, stocks, ect.)
- Other expenses
- Visualizing retirement
Last time we discussed how length of retirement can affect your withdrawal rate. This time we’re going to discuss another risk that needs to be considered, inflation. It has been kind of a hot topic this year after all.
What is inflation anyway?
To start, let’s get a simple definition of inflation down. Investopedia defines it as such “Inflation is a rise in prices, which can be translated as the decline of purchasing power over time” (Source). In short, it’s that a dollar today can buy more than a dollar tomorrow.
Part of the reason we have inflation is to encourage investment, otherwise a very successful risk adjusted strategy would be to sit on a large portion of your net worth, which keeps that money from circulating back into the economy. While it sucks, it does serve a critical role in the economy and in low amounts is not harmful to the overall economy.
Inflation can be caused by a large variety of sources. Such as the increase in the money supply or supply of goods. Over the long term this usually hovers at around 2-4% per year for the United States. I usually just use the middle of 3% for my assumptions, which is close to the more modern average. Like most things in personal finance, I prefer to use the long term average for each year and assume things will level out over time.
Usually this is tracked by watching a basket of goods that consumers buy and tracking how their prices change over time. While there are some problems with how this value is tracked over time, such as changes in consumer preferences, it at least gives us a way to try and track how the buying power of the dollar has changed over time.
If you’re living off of a fixed income of some amount and it is able to buy 3% less every year that could be problematic in the long term. Over 30 years your buying power could have been almost halved. This can seriously mess up your planning.
What can you do?
So the first question is, how do you handle inflation? Obviously stuffing all of your cash in the bank gaining 0.5% or the average currently, you’ll be losing 1.5-2.5% every year. Investing on average earns 10% for stocks and about 4% for bonds. If you account for inflation your real returns come out to 7% and 1% respectively.
For that former number of 7%, you’ll often see me cite that number as the returns you should expect over the extreme long term. But I also have a fairly stock heavy portfolio. But, that’s where these numbers come from. So if you’re using real returns for your projections you’re already accounting for inflation in what your buying power will look like after X number of years.
This also helps with your planning, by using real returns you’re taking an inflation adjustment out of the equation to come up with your number. For instance, I need $1,500,000 in 2023 dollars to retire. The problem is, I don’t know how much 2035 dollars will be worth. But if I take account of returns after inflation, I’m implicitly tracking this number. Yes I’ll need to make inflation adjustments as I get close to retirement to verify, it at least gives me a point to start.
Your withdrawal rate also takes this into account in its ability to maintain your buying power over the long term. Via the return assumptions used to calculate it. If you’re using a modified one, that may change things slightly, but the idea is the same.
What if inflation is higher than 3%
Now you might be wondering what happens if we get into a situation where inflation remains elevated. What if we have a situation like 2022-2023 but where inflation remains elevated for a long time. But is such an event more likely than a period of slightly lower inflation? Will this period last long enough to meaningfully move the average?
But just like preparing for a new bull market or recession there is only so much that you can do about it. We may have a repeat of the stagflation of the 70s but we could also have a repeat of the rock bottom lows of the 2010s. It’s also possible that we have crazy inflation a la Zimbabwe, but at least for the US I don’t think that is a very likely situation.
To put an example to it, if you have a decade of 7% inflation and then twenty years of 3% inflation, your average over that comes out to about 4% per year. While not ideal, especially if your plan was for 3%. Just crunching the numbers real quickly, the buying power of your money would decline by roughly 35% more than anticipated by the end of this period. But if you inflation adjust your returns and you’re making an average of 7% after inflation, your buying power remains unchanged.
Overall, if your plan uses real returns for assets and your withdrawal rate and assumptions most likely inflation won’t be too much of a problem. You’ve planned for the buying power to change and planned such that you can maintain that buying power over the course of your retirement. While inflation that is higher than anticipated could pose issues, just doing a basic adjustment puts you in a fantastic position to protect yourself against unexpected levels of inflation.