Inflation risk for early retirees

Inflation Risk for Early Retirees – Part 1

Inflation – variously described as the dark and pernicious attrition of value, or the lurking unseen risk for early retirees or the…

Actually, no.

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!

Retirement Risks

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:

  1. Delayed Planning
  2. Playing catch-up
  3. Lacking formal retirement income plans
  4. A shrinking advisor pool
  5. 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!

Quantify it!

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%.

Loss in purchasing power from inflation
Loss in purchasing power from inflation

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.

Inflation risk for early retirees
Inflation risk for early retirees

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:

  1. Market returns are 1% (or 100bps) per year less than we expect
  2. Inflation is 1% (or 100 bps) per year more than we expect
  3. Life expectancy is extended by one year
  4. 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.

Sum required at retirement
Sum required at retirement

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.

Inflation risk
Inflation risk

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.

Conclusion?

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?

Technical Notes

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.

36 thoughts on “Inflation Risk for Early Retirees – Part 1”

  1. Where would you like to see things go from here?

    Definitely inflation mitigation techniques – what kind of investment approach is best to act as a hedge against the ravages of inflation.

    What aspects of inflation risk would you like to see uncovered?

    Effect of inflation on your emergency fund and whether you should be holding emergency funds in a particular way to minimise the effect of inflation. Might also be interesting to look at a comparison between the effects of inflation and the effects of fees on an investment portfolio – both are silent killers that can seem like a small issue but (as you’ve demonstrated above) can cost one a lot of money in the long run.

    Is this something that keeps you up at night or have you never considered this a risk?

    I think the rising cost of living for the Millennial generation is just about always a topic of discussion.

    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?

    Existential dread!

    Some other thoughts

    I was asked the other day why global economies aim to have inflation, other than fear of deflation, there doesn’t actually seem to be a particularly good reason for what is seemingly an immutable law of macro economics. The Japanese example (or debacle depending on one’s point of view) is an interesting one, hopefully other economies avoid the same fate. A few other things about inflation that are a bit odd are the importance of the goods and services that are included in the calculation basket (the UK’s CPI measure of inflation conspicuously omits housing costs for example). Also, with enough data, inflation could be calculated down to an individual level. Each individual’s level of inflation will be dependent of the particular goods and services that they tend to buy.

    Thanks for tackling this topic and looking forward to see how the series unfolds.

    HH

    1. Those are all good points. I know ERN has some pretty strong views on emergency funds and has done a good post on this topic.
      I think investment hedges to inflation will be a key area that we will have to really drill into. There is so much that seems like folklore here (e.g. gold is a hedge) that I really want to get into that whole area.
      You touch on another important area. How is the basket of good defined, and how can inflation be ‘personalized’? I’m really hoping to get into that whole area in more detail. So stay tuned!
      Thanks for coming, and don’t be a stranger!

  2. A series on inflatioin is a great idea. I wrote a post a while ago, without deep analysis, on resetting expectations of what a millionaire is to account for inflation.

    I’m looking forward to the rest of the series.

    1. You’re right, a millionaire is not what it once was! And in a decade or two it will be a meaningless label.
      Thanks for coming by Mike.

    1. Yes, I think a big focus of ours will be on key mitigants. TIPS, equities, real estate, gold etc? We will dive into it all.
      Thanks for coming by Jason, I appreciate it.

  3. I would like to see how rising inflation correlates with stock market gains. Because if it is likely to affect the assumed 4% real return and it was somewhat predictable, that would be valuable.

    Thank you for a helpful and often humorous post.

    1. Good point, I’m hoping that ERN will tackle that one! He loves a good macro equity analysis.
      Susan – I’m glad you dropped by; don’t be a stranger!

  4. I’m actually nore interested in how your particular industry deals with inflation and forecasting for things like pension adjustment calculations and the like. I might be the weird one though.

    1. Yep, FTF you’re the weird one 😉 I’m gonna send you to the SoA’s Focus Groups!

      There are broadly three treatments in setting long term inflation assumptions by actuaries:
      1) A mean reversion, long term average type of assumption. This isn’t very sophisticated and its basically what it says on the tin.
      2) Using the Fed target
      3) a market implied assumptions derived from the difference in long term TIPS and nominal bond yields. I prefer #3 personally. I think it has some integrity. I don’t think the market is always right, but I have no more wisdom than the collective wisdom of all the market participants in the TIPS market.
      Thanks for dropping by as always.

  5. Home run. Inflation is about the only thing I worry about. How long does inflation last typically? How is inflation related to market vol? What happens if you get hit by 2 of these buggers say inflation and poor market return? I think the 20+ year bond bull market is dead but that means stocks may be in for a wild ride and possibly poor returns going forward. Not necessarily a crash but we could well see 2% real returns instead of 4% as bonds stocks and interest revert to their respective means.

    I lived through the early 70’s and retiree’s were lucky to afford the early bird special much less trips to China or Viet Nam or some other fancy destination. Especially retiree’s living on interest bearing vehicles like CD ladders. inflation ate them alive. The ease of making 1M in the low volatility of the past 20 years I think is kind of illusory. Hope I’m wrong. I do hold Tips and some gold and I have decreased my AA from 80% stocks to 55% stocks during early retirement as protection from SORR and inflation. I have also reduced my expenditures by 30% in early retirement. I have also over-funded my retirement. My plan is to make it 5 years into retirement without a negative SORR. In 5 years I will hit SS and I will re-retire with a better understanding of my early SORR.

    I’m super glad you are addressing this since most FIRE types were’t around in the 70’s and 80’s to see what this stuff can do in reality. When I went to med school in ’81 I thought I had enough saved to fund my schooling. My tuition was $10,000 when I was accepted. 6 mos later on the day of my matriculation it went up 40% to $14,000 before I started my first class. It doubled in the next year and I was essentially out of money. I wound up going into the Navy for the last 2 years since loans were going for 18% tuition was going crazy and interest started accruing immediately. They paid 2 years and I paid back 2 years of service as an anesthesiologist. This stuff is no joke.

    1. The 70’s were really a dreadful economic period with a severity that few appreciate. It doesn’t get the same sensationalist press of the Great Depression or the GFC, but it was wicked tough. I remember my parents seeing their mortgage interest soar into high double digits, along with massively increased payments. A really ugly time, and it went on for *years*.
      Investors have really been wrapped in cotton wool for the last decade or so. I’m no end-of-the-world freak, but things are about to get more interesting and difficult. What I don’t have a clear idea of, is what part inflation will play in this.

      Thanks for coming by, you’re always welcome.

  6. It would be interesting to cover inflation for hyper growth areas such as healthcare and education costs (for FIRE folks planning to pay for their kids). What kind of curve should we plan with ? It’s unlikely to be a straight 5% or 8% it has been in the last 20 years. What other area will be next ?
    For health care the issues are the long time frame, say 50 or 60 years and the potentially ballooning end of life costs.

    Another factor is taxes to add to inflation, things look rosier ignoring them. This makes TIPS look useless if held in taxable for anyone but the lowest tax brackets.

    1. I’ve been exploring these questions. I’ve had to split out “aspects of inflation” or other portfolio stressors to get some at least qualative understand. For example inflation may be 2% and real growth maybe 4% but medical inflation may be something like 5% but that 5% only applies to a small percentage of costs. Education inflation is another stressor. What if SS gets cut? What if you live 5 years too long? What happens if a spouse dies? This last one is a huge hit on the portfolio. SS income is slashed AND taxes are forced up 2 brackets so the government effectively becomes your new spouse. I use monte carlo to get some idea of tail risk and how to mitigate it. It turns out reliably predicting a 30 year retirement IMHO is far harder than a 25x or 33x strategy.

      One thing not considered by the rear view mirror approach is how is the economy ACTUALLY changing. We used to have 30 year jobs, now often 2 part time jobs or some gig that changes up every decade, We used to have pensions now a myriad of pretax and post tax accounts and the requirement to make tax efficient choices (I keep my LTips in a IRA) How is it going to be when trucks are driven by robots and that 25% of the workforce is unemployed aka what is the effect of creative destruction? (buy robot stocks). Bill Begnan’s 4% rule study looked at historical epochs which could be fundamentally different than what the future will be.

    2. actuary on FIRE

      You raise some good points. No inflation series would be complete without a discussion of healthcare and education. Those costs are out of control.
      TIPS is on the list to look at, and I’m glad you mentioned tax, that has such a big impact on those instruments. Thanks for coming by Paul.

  7. I would be curious to know how accurate predictions of inflation trends were in the past using these prediction methods. I did live through the double digit days and I laughed to see a mere 1% higher inflation as the risk discussion case!

    1. actuary on FIRE

      Although in fairness I assumed +1% inflation for the whole lifetime of over 50 years! So that’s a pretty big stress and probably comparable with double-digit inflation for a few years.
      But now you raise in my mind – is it worse to suffer a short sharp spike, or prolonged inflation? I think the former, since equity returns don’t have time to normalize to the new real returns.
      Thanks for coming by Caroline – I appreciate that!

  8. william bernstein has written that it is foolish to risk money you have and need to get money you don’t have and don’t need. or, as he also put it, if you’ve won the game [accumulated enough], stop playing.

    i don’t know how to stop playing. i don’t mean that i’m addicted to markets. i mean that i don’t know of any absolutely safe way of holding assets, and that is especially the case with regard to inflation risk.

    i think an extended discussion of inflation hedges would be a wonderful thing. the usd was down around 11% last year. it is easy to see a scenario in which the dollar would continue or accelerate its decline, a scenario in which the fed has to abandon its hopes of tightening and return to qe-infinity. this year, with supposedly good growth, the deficit will double to around 1trillion. meanwhile the fed supposedly will roll 420billion in assets off its balance sheet. that means there needs to be buyers for roughly 1.5trillion in treasuries. i don’t see a happy outcome.

    so in the discussion of inflation i think it would be worth talking about scenarios which we associate with em’s, not developed countries. a balance of payments crisis [foreign cb’s have ceased accumulating treasuries] may be in our future, resulting in a sharply devalued dollar and an inflation spike.

    1. actuary on FIRE

      Jeff – you’re right you can’t fully immunize these real liabilities over decades. The longest nominal bonds are around 30 years and TIPS much less. So you always have re-investment risk and the drag from tax. We’re going to be deep-diving into potential inflation hedges – don’t you worry! Thanks for coming by.

      1. here’s a link to a little article comparing cpi-e [experimental cpi for elderly] vs cpi-w [the cpi that social security uses]

        https://www.institutionalinvestor.com/article/b14z9nksqv2wxl/how-inflation-really-looks-in-retirement

        i think tips use cpi-u
        http://www.economicpopulist.org/content/bye-bye-chained-cpi-and-other-budget-surprises-5533

        https://www.financialsense.com/contributors/doug-short/chained-cpi-versus-standard-cpi

        so tips will lag cpi-e. i hold some of my assets in an 8 year tips ladder- i don’t think tips provide adequate inflation hedging for longer periods of time.

        short duration treasuries are actually a pretty good hedge, albeit lagging inflation somewhat. equities are good in moderate inflationary scenarios. gold for extreme scenarios only. foreign currencies?- maybe. commodities would be helpful but unless you’re storing physical you’ll lose on any contango, plus the roll, plus fees.

        it’s hard to hedge inflation. when i shopped annuities some time ago none of the higher rated companies were selling inflation indexed policies, only fixed percentage step-ups.

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  12. Really a great and timely post. I too lived through the 70s inflation. I remember the mindset of my parents was we better hurry and buy because the price will be higher. It is really hard to be concerned about the recent levels of inflation. I hope the fact I hold a significant equity position will mitigate the risk. The first products that I remember waiting to buy because of dropping prices were computers. Interesting. I also remember my first mortgage was 11%. Ouch. Inflation in health care premiums worries me now. Long term care is another worry. I think saving a significant cushion is the best idea. BTW I see you got your 5 extra subscribers and then some. Congrats. My blog is up to 6100 page views and 23 subscribers so far. One month old baby.

    1. Hey Hatton I’m honored at your visit. You’ve got the blogging bug – great work! I want to look into Healthcare inflation at some point.
      Don’t be a stranger…

  13. I was surprised that a 1% inflation required such a large addition to your portfolio. I have *not* lived through the 70s and 80s so this series is going to be a hard education for me, but important. I am now really tempted to follow you on Instagram BTW!! ?

    1. Yeah, remember it’s an additional 1% per year. So it’s sort of a compounding thingy. It’s really like a 1% annual management fee. And FIRE folk would Hyper ventilate at the thought of that.

  14. Can I question your numbers here? I ran the numbers myself and agreed with everything except the 20% crash number. I assume that you’re trying to sort out the impact of sequence of returns, which means that you have the same overall CAGR, but bad returns at the beginning.

    But if you use -20%, followed by +4% every year thereafter, your CAGR will be lower than 4% which was what you used for your comparison nest egg. Which means that some of that 29% increased nest egg is due to the decreased CAGR, and not all is due to the sequence of returns risk.

    When I ran the numbers, I got $1,037,547, which is an increase of 19%, not 29%. I used one year of -20%, then 51 years of +4.536% in order to have a CAGR of 4% over the 52 year period. (I subtracted the spending at the end of the periods).

    I came over from Physcian On Fire, and overall, really great article. Very useful in reminding me to question my assumptions. If I’m planning on average inflation to be 3%, and it actually turns out to be 4%, that will make a big difference in the sustainability of my nest egg.

    1. actuary on FIRE

      Hi Caroline – thanks for visiting. I didn’t try an isolate sequence of returns for the -20% scenario. That was truly a nuclear scenario where you get hit by a market crash early on and you don’t get the full CAGR over the whole period.
      It sounds like you isolated the SORR and got +19% which sounds about right. And when I don’t compensate I get +29%. So +10% is due to the reduced return over the period. I felt that introducing just the SORR would have been a complexity that might have made this a bit harder than needed, so I didn’t bother. But you make a good point.

  15. Have you looked at delaying SS until 70 s a partial inflation “risk reducer”?

    I would love to know your actuarial view on age 70 vs FRA. (66.5 for me) .

    Like gasem I saw the ugly in the 70s and 80s. I’ve been lucky since then…now playing the “one more year” game .

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