The Understated Problem With Inflation

In the previous section we discovered how our 1921 and 2010 retirees faced a more than 5-fold difference in expected safe withdrawal rates because of market valuations and interest rates. In this section we look at our 1966 retiree to learn how inflation affects safe withdrawal rates so we can begin assembling a more complete picture.

The key concept to understand about inflation is how it throws a one-two punch at retirement planning.

1. First, withdrawal amounts are adjusted annually to reflect cumulative inflation, thus forcing a progressively larger annual withdrawal from savings to maintain real purchasing power.

2. Second, periods of high inflation are correlated with lower asset returns (see Unexpected Returns: Understanding Secular Stock Market Cycles).

The combined effect is to increase your annual withdrawals from savings while simultaneously reducing your investment returns—a very difficult situation for any retiree to face. It is the worst of both worlds all at one time because your retirement savings are getting squeezed from both ends simultaneously.

The best historical example illustrating the ravages of inflation was the period from 1966–1996. Surprisingly, it was harder on new retirees than the Great Depression.

Inflation caused the annual withdrawal amount to rise from 4% to above 10% of savings within 15 years of retiring. This also coincided with a nominal return on the S&P 500 of 6.81%, roughly equaling the inflation rate and putting the real return at roughly zero. Numbers like these are unsustainable and spell financial destruction.

The only reason these retirees survived was because Paul Volcker wrenched down inflation, thus setting off one of the greatest bull markets in history beginning in 1982. The subsequent outsized investment returns offset the outrageously high withdrawal rate that had been caused by inflation in the preceding 15 years, thus bailing out a near-death experience for 1960s retirees.

Let me be clear. The 1960s was a warning shot over the bow because the next round of inflation may not end so gracefully. Men of Paul Volcker’s caliber seem in short supply these days and record-breaking bull markets, by definition, are extremely rare occurrences and should not be relied upon to repeat.

The other insidious fact about inflation is that it’s not predictable. PhD economists routinely miss their inflation forecasts just one year into the future. The idea of a 30+ year inflation forecast (the duration of your retirement) is an absurd joke.

In short, inflation is an incredibly dangerous three-headed monster. It can’t be forecasted accurately, it multiplies your spending, and it reduces your average investment returns. This is a destructive combination for every retiree.

Lesson Learned:

Taking inflation-adjusted withdrawals over a 30-year period is only realistic in a stable inflation environment; otherwise, the withdrawal rate grows to an unsustainably large percentage of savings. The bulk of U.S. economic history has seen stable inflation, so there is little historical precedent to judge the seriousness of the problem. Foreign history includes bouts of inflation and the effects indicate safe withdrawal rates below 4%. Given the unprecedented government debt levels, you should carefully reconsider any safe withdrawal rate that blindly increases spending during inflation.