INFLATION & YOUR RETIREMENT PLANNING
Most investors, when considering their financial future, have a common concern – that they will not have saved enough to sustain them in retirement. In other words, they fear that they will outlive their money. Even those with high incomes and significant assets are not immune to this worry.
Thankfully, many are diligent about saving and investing. Some turn to professional advisors to help them model their savings needs throughout their careers to make sure they are “on track.” Whether done with an advisor or modeled on one’s own using a simple spreadsheet, inflation is an important factor that must be considered when projecting future spending. Inflation, like other key assumptions for financial modeling, such as future income, expenses, investment returns, and health, is not stagnant and changes over time.
As we all know, inflation has risen significantly over the last year or so. Not only does this impact our present spending and cash flow, but it has led many investors to rethink their retirement projections, including higher inflation rates for those models. In this article, we will discuss the all-important factor of inflation and consider what inflation rate should be used in retirement modeling.
Inflation Today and Long-Term Inflation Rate Assumptions
With good reason, inflation has been on the minds of many. Last year, the annual inflation rate was 6.5%. At its peak in June 2022, it was 9.1% and even year-to-date, it has been 4.9%.[1] As you will see, these are much higher rates than we have been accustomed to, and, as such, concerns about inflation have increased.
Since retirement projections will span a few decades for an older investor – and 50+ years for a younger person – looking at the inflation rates over the last year or 18 months is not helpful. We need more data and a longer time period. If we examine inflation over the last 20 years, the average rate has been 2.25%; over 30 years, it has been about 2.5%. If we want to go back over 100 years, we can look at the CPI all the way back to 1921, where the average has been 3.21%.[2] Typically, the advisors at OJM Group use the 30-year average of 2.5% as the starting point for a client’s retirement projection.
The CPI: Is it the Right Measure for Retirement Modeling?
When most people discuss an inflation rate, including our data above, they refer to the Consumer Price Index (CPI). This is the most common standard used in the U.S. to measure inflation. Importantly, housing is almost one third of the CPI. This heavy weight for housing may make sense for the general population, as many people have a large rent or mortgage expense in their monthly budget.
However, for many high-net-worth individuals, this will not be the case in retirement. Some will have either a fixed rate mortgage for housing costs, or no mortgage at all by the time they retire. As such, using the full CPI rate for retirement projections may be higher than realistic. Generally, for retirement projection purposes, it may make sense to reduce the 30-year average of 2.5% to an inflation rate between 2.0% and 2.2%, depending on the pre-retiree’s likely housing situation.
What About the Investment Return Assumption?
When building out retirement models, investors and their advisors should consider erring on the side of conservatism when selecting an investment return assumption, especially during retirement years. Thinking one is “on track” when using high return assumptions often means taking on more risk in one’s portfolio. This can be especially problematic in retirement because of the sequence of returns risk, which is the danger that the timing of liquidation and withdrawal from a retirement account will coincide with a downturn in the market.
It may be wiser to use a conservative investment rate of return in retirement. For one, this allows the investor to reduce risk in the portfolio. If financial goals can be met without taking on excessive risk, why not do that? Further, if a portfolio designed to earn a lower (conservative) rate of return outperforms, the results are even better for the retiree and his or her family.
Third, by using a conservative rate of return, inflation can work for a retiree on the investment side, even as it works against them on expenses. In essence, in times of higher inflation, the most conservative investments may have an opportunity to provide a decent return, which could be enough to sustain a portfolio that only needs to meet conservative assumptions.
Consider today as an example. Let’s assume Physician Phil had built a retirement projection where he only needs to get a 5% return now that he is retired. With inflation elevated over the last year, he might be able to get a large portion of the return he needs simply from a money market account. He could allocate just a small fraction of the investments to higher risk assets to make the 5% that he needs. In this way, Phil benefits from today’s higher inflation on the investment side of the spending-earning balance.
The Key is the Spread Between Inflation & Investment Rate
In the example above, we see that inflation can be a “double edged sword.” It can eat away at purchasing power and thus require more dollars in retirement to sustain a lifestyle. Conversely, inflation is also associated with higher interest rates which can make returns on cash and cash equivalents (like money market funds) rise. In this way, the spread between investment returns and the inflation rate becomes more important for retirement projections than the nominal inflation rate.
If inflation is higher than average, cash is going to earn higher than normal returns and bond yields are also going to be higher. As an example, if inflation is running at 3.5% long term (1/3 higher than its 30-year average), there is a reasonable expectation bonds will be yielding over 5% and a 60% equity-40% bond portfolio could earn closer to a historical average of around 7%. In other words, if inflation is higher than its historical average, we would expect that conservative asset classes will have higher than average returns as well, so dynamic retirement portfolios could move in step with inflation and not harm the client’s retirement.
Of course, this may not always be the case and gets back to why building conservative retirement projections on both the expense side (including the inflation factor) and investment return side is crucial, as is adjusting them each year as one works and as one lives off the assets in retirement.
Conclusion
There are many dynamic factors that impact long term financial goals, including retirement. A professional advisor can be extremely helpful in crafting a realistic retirement model with built-in flexibility to adapt to changes in inflation rates, tax rates, expenses and investment returns.