Inflation – variously described as the dark and pernicious attrition of value, or the lurking unseen risk for early retirees or the…
Inflation Risks for Early Retirees
I’ve never seen inflation earn much of a headline for retirees. It always seems to come way down the hierarchy in any list of retirement risks. The sexy risks like market crashes and sequence of returns seem to get all the press, and actuaries obsess over life expectancy and outliving your savings, but inflation rarely gets much of a mention.
So is inflation a risk to the current crop of early retirees? Is this something you should be worried about, how does it rank among other risks, and how can you mitigate its impact?
Well, dear reader, I have good news, because my fellow blogger ERN over at Early Retirement Now and I are teaming up to give this topic a good kicking. What can you expect? We’re going to be doing a series of posts that feature:
- Fact-based empirical data analysis
- Slaying of sacred cows
- Rigorous hypothesis testing
- Cool charts!
- Lame attempts at humor (Hey! work with us, we’re tackling some tough material here!)
- Even more cool charts!
I know, I’m excited and really looking forward to this.
But first, please read the important notes before proceeding further.
++UPDATE 2019++ Do you want to know when you can become financially independent? Check out my new course – Create a kickass financial independence spreadsheet – for beginners. It has a 30 day money-back guarantee so risk-free!
Before we dive into any analysis, let’s look at what the investment establishment has to say about retirement risks, and where does inflation feature, if at all?
As luck would have it, the Society of Actuaries published a report last year entitled “Post-Retirement Risks and Related Decisions”. They have a summary table of eight risks and number five is our friend inflation risk. As expected number 1 is life expectancy and outliving your assets. (See what I told you? Actuaries love telling people they are going to live too long.) Other notable risks include medical costs and long-term care costs.
Interestingly they observed that inflation has been in the top three risks described by people in their annual Risk Survey and Focus Groups, and they go on to suggest that there is a disconnect between people’s perception of risks and experts’ views of risks. [As a side note, can you imagine getting pulled into a Society of Actuaries Focus Group? You’ll be lectured for hours about how you are going to live too long *Shudder*]
The Investments & Wealth Institute (a professional body for Financial Planners) published a report “Five Challenges Facing the Next Wave of Retirees” that addresses several specific challenges that future retirees and their advisors will face. Here are the five challenges:
- Delayed Planning
- Playing catch-up
- Lacking formal retirement income plans
- A shrinking advisor pool
- Delayed succession planning among advisors
Not a sniff of inflation anywhere here.
I’ll spare you the details from other reports I found, but inflation risk did not feature prominently in the list of retiree risks. Is this because traditionally retirement is seen as an activity from age 60 onwards, and inflation is less of a risk to these ‘traditional’ retirees than the very early retirees from the FIRE community?
Come join ERN and I on a voyage of discovery to probe these issues!
What is inflation?
You might have noticed that prices tend to rise. Things are just more expensive in general than they were years ago, or viewed differently, the dollar in your pocket can purchase fewer goods than you could in the past. You might think this is undesirable but economists welcome a low level of inflation and the Federal Reserve even has a dual mandate to maintain a steady low level of inflation in addition to full employment.
In fact, what economists really fear is deflation where prices decrease, and so maintaining a low inflation rate provides a buffer against deflation. You might think that prices going down sounds great, but serious economic stagnation usually follows. In a deflationary environment everyone postpones their spending in the expectation that prices will be lower in the future. Without spending and consumers, the traditional capitalist economy grinds to a halt, and Japan has been the standard bearer for this unfortunate situation in recent decades.
So inflation is here to stay and it is built into our economic system. Get used to it and learn how to manage its impact on your retirement success!
Oh yeah – you’re right – words, words, words – what we need are some calculations and a chart!
Imagine you start with $1,000,000 at the beginning of your retirement and just put it under your mattress. Due to inflation that sum will lose purchasing power. You will still have $1m but every year that sum can buy fewer and fewer goods. The following chart shows the erosion in purchasing power under three different inflation rates: 2%, 2.5% and 3%.
After 25 years under a 2% per year inflation rate your $1m is worth only $600k in current money terms. Under a 3% per year inflation rate it will be worth a paltry $470k. So inflation has eroded over half your purchasing power!
Also let’s be clear that 25 years is not a long period. Even for regular retirees from age 60 or 65 a 25 year horizon is perfectly reasonable. If you’re hoping to retire in your 40’s, 50’s or earlier then this impact is real.
Based on these results inflation certainly seems like a real risk.
Do you want to be alerted to future episodes of the inflation series? Simply sign up your email and I’ll keep it safe and only notify you when there are hot new goods. Also follow me on Twitter @actuaryonfire and ERN @earlyretirementnow. Don’t bother trying to follow me on Instagram. In fact I question why you would want to look at pictures from an actuary, that sounds pretty dull to me.
How Do We Mitigate This?
I hope you’re convinced from the above that inflation is a serious headwind in your retirement, but what tailwinds can assist us?
The key one is to ensure that your investment portfolio performs at least in line with inflationary increases. In reality you won’t be keeping your assets under a mattress (I hope) and will be investing in various investments. In terms of investment returns you need to run to stand still. If inflation is 2% a year then your investments need to generate annual returns of 2% simply to maintain purchasing power. If your investments return 3% in a 2% inflationary environment then your purchasing power will grow by 1%.
This is a key point; we should not be interested in investment returns alone, it is the return in excess of inflation that counts.
If you want to join Actuary Club (but don’t ever talk about Actuary Club) then refer to pure investment returns as “nominal” returns, and returns in excess of inflation as “real” returns. That’s why you will always see ERN and I doing calculations with real returns. [Don’t worry, members of Actuary Club aren’t forced to attend the Society of Actuaries Focus Groups.]
In future episodes we will be exploring whether certain investments display a reliable real return.
How Much Risk?
This episode is really a primer to whet your appetite, but let’s look at how we might quantify this risk. We are going to look at how much money an early retiree might need in retirement and examine how much more money will be required under the following scenarios:
- Market returns are 1% (or 100bps) per year less than we expect
- Inflation is 1% (or 100 bps) per year more than we expect
- Life expectancy is extended by one year
- The market crashes in the first year of retirement and the portfolio loses 20% of its value ‘
For this example, we will take a female early retiree at age 50 who is in good health and requires an annual spend of $40,000. The Society of Actuaries longevity illustrator says that this person has a 1 in 10 chance of living another 52 years (yikes!). We will also assume that her portfolio might earn real returns of 4% a year.
What is the sum required today in order to meet this commitment for the rest of her life?
This is pretty easy to calculate with Excel and the present value function, and it is $869k. I’m sure that with the 4% rule of thumb you were expecting that a sum of $1,000,000 would be required. I’m assuming here that her capital would be eroded and she is left with zero at the end. That’s not really important for this illustration, since it’s not the absolute amount I am worried about, we are interested in the relative impact of the above risks.
The above chart show the sum required at retirement. You can see that in order to provide an income of $40k in retirement under a scenario where inflation is 1% per year higher than expected the sum would rise from $869k to $1,046k. In contrast, under a market crash scenario you would need $1,120k in the bank to sustain your $40k per year.
Let’s show this as a percentage increase on the baseline amount.
There are some quick takeaways here:
- The additional sum to protect against a 1% per year increase in inflation is around 20%.
- The additional sum required for a reduction in portfolio return of 1% per year is identical to the inflation scenario.
- Living an additional year simply requires saving an additional 1%. That’s a tiny additional amount.
- As you might expect the market crash in year 1 is the most severe scenario and requires additional capital of 29%.
- The inflation scenario results in a financial impact of around two-thirds of the market crash scenario.
Above I have quantified the financial impact of unexpectedly high inflation and compared it to some other risks. The nuclear risk is on the right in the above chart. Losing 20% of your portfolio in your first year of retirement is the nightmare scenario. If you want to mitigate this then you need to save an additional 29%. That’s a huge additional cushion to mitigate this rare risk.
Clearly inflation is less severe in financial terms, but it is not trivial. In broad terms the financial impact on an early retiree of higher than expected inflation might be around two-thirds of a market crash. If you want protect yourself against inflation being 1% per year higher than expected then you need to save an additional 20% to feather your nest. That’s a pretty big additional cushion.
What we don’t have a feel for at this stage is the risk that inflation could be 1% per year higher than expected. This seems to be a pretty unlikely event and I chose it to make the example simple, but in later episodes we’ll look at how likely this might be.
If you enjoyed that then check out Part 3 on calculating personal inflation rates Part 3
This first episode was a gentle introduction, but where would you like to see things go from here? What aspects of inflation risk would you like to see uncovered? Is this something that keeps you up at night or have you never considered this a risk? Would you like to attend the Society of Actuaries focus groups on retirement risks, or does that thought fill you with a deep existential dread?
You might be surprised that living an extra year is not as big a financial risk as you thought. When you factor in a fairly high real discount rate of 4% then the 53rd payment gets discounted to oblivion. So the additional reserve required is pretty low.
You might wonder why the additional reserve for the first two scenarios, a 100bps increase in inflation, or a 100bps reduction in real return, are identical. This is simply math. They are actually identical scenarios just said a different way. A 100bps increase in inflation is identical to a 100bps reduction in real return, absent other changes.
If you follow the usual FIRE method of reserving a sufficient sum so as not to erode your principal, then you arrive at slightly different results, but qualitatively the same. I didn’t do it that way as I would get booted out of Actuary Club for such wantonly high reserving.