Inflation 101 – What to know, what to do
Inflation is perhaps the single-biggest influence on your economic situation. It is not properly understood by many, nor do many people make good decisions in light of it.
Peoples Bank is making the effort to address what may be an important gap in the financial efforts of its customers and others with 4 blog posts. We hope this information is more than instructive, we hope that it is meaningful, helpful. Feel free to write us with your comments, and don’t hesitate to share the link with others.
The first installment defined the term and describe it in real-world terms while the second one described what you can do about it (personally) and what tools are available to deal with bonds. The final post in the series is about how your retirement can be improved by dealing with it.
Inflation Doesn’t Retire When You Do
The need to outpace inflation doesn’t end at retirement; in fact, it becomes even more important. If you’re living on a fixed income, you need to make sure your investing strategy takes inflation into account. Otherwise, you may have less buying power in the later years of your retirement because your income doesn’t stretch as far.
Your savings may need to last longer than you think
Gains in life expectancy have been dramatic. According to the National Center for Health Statistics, people today can expect to live more than 30 years longer than they did a century ago. Individuals who reached age 65 in 1950 could expect to live an average of 14 years more, to age 79; now a 65-year-old might expect to live for roughly an additional 19 years. Assuming inflation continues to increase over that time, the income you’ll need will continue to grow each year. That means you’ll need to think carefully about how to structure your portfolio to provide an appropriate withdrawal rate, especially in the early years of retirement.
Adjusting withdrawals for inflation
Inflation is the reason that the rate at which you take money out of your portfolio is so important. A simple example illustrates the problem. If a $1 million portfolio is invested in an account that yields 5%, it provides $50,000 of annual income. But if annual inflation runs at a 3% rate, then more income – $51,500 – would be needed the next year to preserve purchasing power. Since the account provides only $50,000 of income, $1,500 must also be withdrawn from the principal to meet retirement expenses. That principal reduction, in turn, reduces the portfolio’s ability to produce income the following year. In a straight linear model, the principal reductions accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of the withdrawals.
A seminal study on withdrawal rates for tax-deferred retirement accounts (William P. Bengen, “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning, October 1994), using balanced portfolios of large-cap equities and bonds, found that a withdrawal rate of a bit over 4% would provide inflation-adjusted income (over historical scenarios) for at least 30 years. More recently, Bengen showed that it is possible to set a higher initial withdrawal rate (closer to 5%) during early active retirement years if withdrawals in later retirement years grow more slowly than inflation.
Invest some money for growth
Some retirees put all their investments into bonds when they retire, only to find that doing so doesn’t account for the impact of inflation. If you’re fairly certain that your planned withdrawal rate will leave you with a comfortable financial cushion and it’s unlikely you’ll spend down your entire nest egg in retirement, congratulations! However, if you want to try to help your income – no matter how large or small – at least keep up with inflation, consider including a growth component in your portfolio.
Installment 3: Inflation and Bonds: The Ups and Downs.
Check out the whole series
Contact our Peoples Investment Services, Inc. representative at 828-464-5620 or www.raymondjames.com/PeoplesInvSvcs.
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