In my last post, I wrote about the recent spike in inflation, which seems to be mostly caused by shocks to the economy from the pandemic. The Consumer Price Index (CPI) is currently indicating a relatively high annual inflation rate of 5.4% between September 2020 and September 2021. However, last time I also presented evidence suggesting that inflation will likely recede within a year or so back to its previous level of around 2%.
The problem is that there is no sure way to predict the future. So, in today’s post, I want to further consider what might happen to investors if high inflation lingers for several more years. Specifically, I’ll focus on how rising inflation impacts retirement savers, those nearing retirement, and current retirees.
The reason that inflation is important to retirement investing, and other long-term investing ventures, is that most investing plans assume a rate of inflation for:
- Determining when it’s safe to retire.
- Setting retirement savings withdrawal rates to maintain an accustomed quality of life.
Let’s look at each situation separately.
Inflation When Saving For Retirement
As an example, let’s say you’re planning to retire 10 years from now and hope to live off of about 80% of the current U.S. household median income¹, which equates to $50,000.
But that retirement spending will take place 10 years from now. And as inflation continues over those 10 years, that $50K will have less purchasing power than it does now. So, we have to “inflation adjust” the $50K of expected spending to reflect future economic conditions.
The higher the rate of inflation over the next 10 years, the more you will have to save and/or the better your investments will have to perform to meet your retirement spending target (or expected “retirement income”). This graph shows how much your inflation-adjusted retirement income will need to change depending on various levels of inflation rates over the next 10 years.
If the current inflation of 5% continues for the next 10 years, your inflation-adjusted spending target at the start of retirement would be nearly $78,000 to maintain the quality of life you experience today with an income of $50,000. And even if inflation quickly returns to 2%, you’re still looking at an inflation-adjusted spending target of about $60,000 for a retirement that starts 10 years from now.
I should note that the worst 10-year annualized inflation rate in history going back to 1871² was 8.7%, which occurred during the highly unusual stagflation conditions of the 1970s and early 1980s. Even a sustained decade-long inflation rate of 5% is pretty unusual as this graph of past decades from Inflation Data shows.
So, although the 8% and 9% inflation-adjusted spending targets look pretty scary, they aren’t that likely to occur.
Inflation Once Retired
Maybe you’re mostly past the saving phase and you’re already retired or expect to retire soon. For this situation, let’s look at two examples that maintain an annual inflation-adjusted retirement spending target of $60K and $78K, respectively³. Let’s further assume that you’re a mindful investor and you maintain an investment portfolio comprised mostly of low-cost stock index funds. Finally, let’s assume you want to retire early and expect to have a 40-year retirement.
Constant Growth – With these inputs, we can estimate the growth of your investment portfolio using the long-term nominal (not inflation-adjusted) annualized return of the S&P 500 of about 9%.² The big question for most retirees is whether your nest egg is large enough to provide your desired inflation-adjusted spending target (this time I’m going to call it a “withdrawal rate”) across a reasonable range of potential future conditions.
So, let’s look at how big your nest egg would need to be to avoid running out of money in 40 years across a range of prevailing inflation rates as shown in this graph.
If you’re trying to maintain today’s $60K spending lifestyle, and the annualized inflation over the next 40 years is 2%, the orange line in the graph shows that you’d need at least $797,000 saved up in today’s nest egg. But if inflation turns out to be 6%, you’d need at least $1,346,000 saved up. You can make similar comparisons for the $78K spending target using the blue line in the graph.
Again, I should note that the worst 40-year annualized inflation rate going back to 1871² is 4.7%, which occurred from 1941 to 1980. So, the highest dollar values shown in the above graph represent nest eggs that are pretty darn safe.
Variable Growth – The above calculations assume that stocks return 9% nominal every year for 40 years without variation. But stocks tend to go mostly up and sometimes down over the years, which creates a more variable growth trajectory.
For this reason, I’ve written quite a lot about how an unusually poor “sequence of returns” early in retirement has the potential to drain a portfolio before retirement ends. It turns out that retirement portfolio failure occurs less often than you might expect assuming that you’ve saved up a reasonable amount. Nonetheless, looking at a very pessimistic case of variable growth helps illustrate the potential double whammy of long-term low returns and high inflation.
For this calculation, I picked the 40 years from 1881 to 1920, when U.S. stocks had an annualized nominal return of just 5.5%². It’s one of the worst 40 years in stock investing history. Here’s the same graph as before, but using this bad 40-year sequence of returns to determine portfolio growth.
As compared to the 9% constant growth projections, these numbers quickly get out of hand. We’ve gone from a required nest egg of less than $1 million at the low end of the constant growth projections to a high end of over $3 million in this pessimistic variable growth projection!
What Can We Do?
Regardless of whether you’re decades away from retiring or already in retirement like me, coming up with an additional $2 million to protect against unlikely long-term high inflation isn’t realistic. So, what actions can investors take to protect against these unlikely doomsday inflation scenarios?
Because these worst scenarios are so unlikely, I think it’s more helpful to think in terms of how we can bolster our retirement plans to mitigate episodes of rising inflation as much as possible.
Save More – If you’re still saving for retirement, the most obvious and powerful response to rising inflation is to save and invest more money. In terms of building a long-term retirement nest egg, simple math shows incontrovertibly that saving rates trump investment return rates every time.
I realize that the advice to save and invest more is easy to give and hard to take. But there’s more than one way to skin this cat.
One way to save more is the traditional tighten-your-belt approach, where you sock away more money from the same income. But of course, when inflation is running high, you have even less money left after spending on the same quality of life.
The other way to save more is to exploit high inflation in your favor. In my old company, this is the time of year when we owners determined cost-of-living pay increases for the following year mostly based on the CPI. And plenty of evidence indicates inflation is rising at least in part because employers are raising wages to attract scarce workers.
In other words, take advantage of the fact that your labor is a premium resource right now. Ask your employer for a cost-of-living adjustment (COLA) that recognizes the rising inflation rate. And help them understand that because labor is scarce, replacing you might be more costly than giving you a fair COLA raise. Of course, it’s best to avoid outright threats; diplomatically implied threats are so much more persuasive.
Also, you might consider offering your employer some other trade-offs that increase your salary. For example, maybe your employer wants you to stop working from home and come back to the office. Use that, along with the inflation argument, to negotiate a wage increase that recognizes the less favorable working conditions.
And once you secure that raise, the key is to save and invest all the extra money by acting as if you never got the raise in the first place.
Reduce Retirement Spending – Retireees obviously can’t ask anyone for more money with the exception that Social Security regularly issues an annual COLA, which is expected to be almost 6% for 2022. So, for retirees, the key is simply spending less. Again, this sounds tough, but the required sacrifices can often be less severe than you might assume.
I wrote a post about a recent retirement analysis of historical stock return data by Javiar Estrada showing that the probabilities of having to reduce spending in retirement due to a poor sequence of stock returns are pretty low, even on an inflation-adjusted basis. Estrada even provides a specific method for deciding on and making real-time, and usually temporary, retirement spending adjustments that greatly minimize the potential for running out of money in almost any set of market and economic conditions.
My favorite way of spending less in retirement is to simply not inflation-adjust my withdrawal rates for as many years as possible. Although my retirement plan assumes inflation-adjusted withdrawal rates, I’ve been able to keep my nominal withdrawal and spending rates the same over the last five years. If inflationary pressures linger or increase, I’ll eventually need to raise my withdrawal rate. But so far, this little trick has been pretty painless.
Inflation Hedging – I’ve already written too many posts about inflation hedging and even talked about it a little again in my last post. Suffice it to say that picking assets that consistently excel when inflation rises is difficult to near impossible. The one exception is Treasury Inflation-Protected Securities (TIPS) and Inflation Savings Bonds (I-Bonds), the yields of which are adjusted by the CPI. While stocks will almost always provide a better long-term nominal return, TIPS and I-Bonds will generally perform very well in years when unexpected or sudden inflation occurs. A portfolio of stocks and some TIPS increases your “inflation diversification”.
Your Personal Rate of Inflation – Another thing to consider is that the rate of inflation is not the same for everyone. For example, here are the recent annual (September 2020 to September 2021) statistics from the CPI by region:
- Northeast – 4.6%
- Midwest – 5.7%
- South – 5.8%
- West 5.3%.
And here’s the CPI for Class A cities (population >1.5 million) versus Class B/C cities (population between 50K and 1.5 million):
- Class A Cities – 4.8%
- Class B/C Cities – 5.9%.
So, if you’re living in a mid-sized Southern city, you’re likely seeing a percent or more in inflation than someone living in a big city in the Northeast.
Because constantly moving to chase lower inflation rates is not practical, and probably not effective at reducing the cost of living, the variations in inflation across different consumer goods and services are perhaps more useful. Here are some examples:
- Food at home – 4.5%
- Food away from home – 4.7%
- Beef and veal – 17.6%
- Fruits and vegetables – 3.0%
- Gasoline – 42.1% (Yikes!)
- Fuel Oil – 42.6%
- Electricity – 5.2%
- Natural gas – 20.6%
- New Vehicles – 8.7%
- Used Vehicles – 24.4%
- Televisions – 12.7%
- Audio equipment – negative 8.6%
- Apparel – 3.4%
- Medical Care Commodities – 1.6%
- Shelter – 3.2%
- Transportation – 4.4%
- Medical Care Services – 0.9%
Maybe you’re considering buying a new television, but these data suggest you’ll get a much better deal on new audio equipment instead. Of course, like the problem of impulse buying at “sales” events, you can’t increase your savings rate by spending more than you otherwise would have in the first place.
As an experiment, I looked at the average spending habits of U.S. consumers and made simple estimates of how the personal rate of inflation would vary depending on a few changes to a retiree’s purchasing patterns. Here’s the personal rate of inflation for two examples4:
- A home-owning retiree who drives a gas-guzzling RV all over the country and eats lots of red meat – 7.8%
- A vegetarian retiree who hikes and skis locally – 3.3%.
But you don’t have to conduct calculations to benefit from these CPI data. You can simply identify the most inflationary items in your budget and consider spending changes that would reduce your personal rate of inflation.
The larger point is that it’s easy to look at the top line CPI number and assume that we’re all doomed to experience that one level of inflation. However, there are opportunities to reduce your personal rate of inflation. And understanding that fact might give you more incentive and greater flexibility to spend less and save more.
Conclusions
While long-term high inflation can have powerful negative impacts on retirement saving and spending, we’ve found at least two important mitigating factors to help you sleep at night.
First, as far as anyone can tell right now, persistently high inflation appears to be an unlikely scenario for the next few years, much less for decades. The briefer these spikes in inflation are, either now or in the future, the less impact they have on long-term spending targets and nest egg retirements.
Second, you are not entirely powerless in the face of rising inflation. I’ve offered you multiple practical ways to bolster your retirement security both now and in the future, should inflationary pressures worsen or prolong. I’m sure there are some other inflation mitigation tools out there that I haven’t yet mentioned, but I’ll leave that for another day.
1 – This 80% rule-of-thumb is based on the idea that overall expenses tend to decrease in retirement. However, there’s a fair amount of evidence that this assumption is too simplistic. Some people prefer to assume that retirement spending will vary across the phases of retirement from relatively healthy and active at the start to relatively infirm at the end.
2 – I’m using Robert Shiller’s historical inflation and stock return data.
3 – These two dollar values would be equivalent to the previous $50K spending target example assuming that 10 years of 2% or 5% inflation occurred before retirement, respectively.
4 – I should note that my numbers likely vary substantially from what you’d get by attempting a similar calculation using the “market basket approach” developed for the CPI. That’s because I didn’t want to drown in a pretty darn complicated CPI methodology just to make a simple point.
