The inflation wars are heating up. Central bankers continue the fight while the political class falters under pressure from workers who want higher wages and an end to interest rate increases. The way to stop inflation is to the slow the economy. This is bitter pill to swallow for society as workers are left unemployed and governments lose support from voters. In the short run many of the remedies for inflation can seem worse than the underlying problem.

Over the longer run the impact of inflation is ruinous to the economy and society. It is especially painful for retirees. There is no offset to cost of living increases through higher salaries. And it becomes more challenging to manage and drawdown retirement savings. This is a topic we explored on a recent episode of our podcast Investing Compass. 

The goal of retirement planning is to maintain an inflation adjusted – or real - standard of living while not running out of money before death. The mechanism to do this is to manage the withdrawal rate or how much you take out of your portfolio each year in retirement.
One of the most famous rules in investing is the 4% rule. The premise is simple. In the first year of retirement 4% of a portfolio is withdrawn with the dollar figure increasing each year by the level of inflation.

How long a portfolio will last is a function of the returns received, the order of those returns and how much is taken out of a portfolio each year. Inflation impacts all three of these variables. And we must remember that the 4% rule is based on historic market conditions.

For a retiree today we must look forward for a realistic withdrawal rate. Inflation is a key consideration.

How inflation impacts withdrawals from your portfolio

Compounding is earning returns on your returns. This can be an incredibly powerful way to grow your wealth. But the impact of compounding works both ways.

In retirement high inflation and the need to maintain a consistent standard of living can accelerate withdrawals from your portfolio. We can explore two scenarios. If you are taking 4% of a $1,000,000 portfolio in the first year of retirement you have $40,000 to support your living expenses. That is the for the first year of retirement. In subsequent years to maintain your standard of living you would increase the $40,000 by the rate of inflation.

At a 2% average rate of inflation over a 30-year retirement means a $71,033 withdrawal in the last year of retirement. That is the amount of money needed to support the same standard of living as the $40,000 that was originally withdrawn. Over a 30-year retirement your total withdrawals would be $1,622,000. That is more than the original size of your portfolio at retirement. The difference needs to be made up by the returns you earn while retired.

There are large impacts if inflation averages 5%. At the end of the 30 years, you would take out $164,000. Over the life of the retirement your portfolio now needs to support $2,657,000 of withdrawals. That is a big difference.

Returns in an inflationary environment

To compensate for higher withdrawals from your portfolio it is necessary to earn higher returns. But that can be challenging. An inflationary environment is not conducive to high returns.

The reason we invest is to earn returns that exceed inflation. We want our money to grow faster than the purchasing power of that money decreases. That is how we grow our wealth. Since 1900 Australian shares have delivered returns in excess of inflation of 6.7% a year.

However, according to an article in Firstlinks by Ashley Owen there is a large difference between returns in high inflation years and low inflation years. In low inflation years Australian shares delivered returns in excess of inflation by 13%. In high inflation years the return exceeded inflation by half a percent a year. Global shares mirrored Australia.

The picture turns more dire when looking at other asset classes. In those same high inflation years precious metals, cash, Aussie government bonds and US government bonds all delivered negative real returns. That means that they went up in value less than inflation.

How to respond to this environment

As the political will to fight inflation recedes and the deflationary forces that have influenced the global economy since the early 1980s erode, we might need to at least prepare for a prolonged period of elevated inflation. There is no easy solution for retirees but there are four steps you can take.

1. Reduce your withdrawal rate

If you are not yet retired consider lowering the withdrawal rate you use as part of your retirement plan. This will entail some sacrifice. It means you will either have less money to spend each year or it means that you need a bigger portfolio at retirement. That means more savings and / or delaying your retirement.

2. Slowing the growth of your withdrawals

There is official inflation and there is the inflation that applies to each of us individually. Official inflation is measured by the changes in prices of a basket of goods that is intended to represent the average person.

Each of us is unique and it is important to consider your personal inflation rate. It might be higher. It might be lower. The last reading of inflation in Australia came in at 5.6%. The housing component of that was 8.4%. If you own your home that may not apply to you.
Increasing the amount that you withdraw from your portfolio less than inflation will have a significant impact over time.

3. Adjusting the way you invest

All asset classes had lower real returns in higher inflation environments. But shares still performed better than fixed interest and cash. Over the long-term – and yes retirement still counts as the long-term – shares have provided higher returns than other asset classes. Don’t get too conservative in your asset allocation because in a higher inflation world you will need higher returns.

4. Explore inflation protection

There are ways that retirees can get protection from inflation. Annuities are one example where there are options to received inflation protected income. Even using a portion of your portfolio to purchase a CPI protected annuity can provide a respite if higher inflation is here to stay.