Shani Jayamanne: Welcome to another episode of investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs. 

Mark LaMonica: So Shani we have another competition that I believe we mentioned on the podcast previous to this but we will remind everybody that for anyone who leaves us a comment on their podcast app and then emails that to my email address which is in the show notes - we are going to give away 5 Amazon echo dots, which is exciting.

Jayamanne: It is exciting. I’ve figured out another reason why I enjoy using mine which is that every morning I say, “Alexa good morning” and then it tells me how many days left until my next holiday.

LaMonica: Okay well that’s exciting so that feature is not available to everyone, they won’t tell you when Shani’s next vacation is, but you can put your own vacation in there.

Jayamanne: Exactly it.

LaMonica: Okay so we had a recent market update podcast that we put out and we focused on how debt exploded after a period of low interest rates culminating in the drop to almost zero in the face of COVID. But we only briefly touched on the other impact of the easy money era – the persistent inflation that the global economy is experiencing.  

Jayamanne: And inflation is still high and at least so far has not been brought under control. And in a way we are seeing inflation embed itself within the economy in ways that might make it harder to get rid of. And simplistically the way that inflation embeds itself is that prices go up of goods and services which causes workers to demand higher pay which makes creating goods and services more expensive since labour is such a big part of the cost to do anything. 

LaMonica: This is a bit of an aside but on Sunday a homeless woman approached me and asked me to buy her food. And I asked her what she wanted, and she wanted frozen yogurt from some bougie self-serve yogurt place around the corner from my apartment. So she got a cup and got her yogurt and toppings and it cost $26. 

Jayamanne: That is a lot to pay for frozen yogurt. 

LaMonica: Especially since it is self-serve. 

Jayamanne: I think we are all having moments like this when we are shocked at what something costs. And this is how we often think about inflation – the strains it is putting on many people’s budgets.  

LaMonica: And this economic hardship means that many people who were already struggling are faced with dire choices. So please remember those people during this difficult economic time and look for ways to help. 

But this whole podcast is not going to be about frozen yogurt. We want to spend a bit of time talking about how higher inflation can impact retirement. And we will touch on some core concepts of retirement that will be useful for everyone no matter how far retirement may be away for you. 

Jayamanne: So this will also be pertinent for people approaching retirement or are in retirement.  

LaMonica: Now we are specifically going to talk about what the considerations are with retirement planning if inflation stays in the 4 to 5% range instead of the 2% of lower inflation we’ve seen for a good while until COVID.  

Jayamanne: And this is where we need to go back to the basics tenants of retirement planning which is based on a safe withdrawal rate and the notion that during retirement many people are looking to maintain a steady real standard of living. 

LaMonica: And we’ve talked about this multiple times but as a quick reminder the withdrawal rate is really crucial in retirement planning because what you are looking to establish is an amount of your portfolio that you can spend each year that will last you until death when you don’t know when you will die and don’t know the returns and the order of returns you will receive during retirement.  

Jayamanne: And this withdrawal rate is critical because it governs how much you need to retire. If your retirement spending needs are $50k a year and the safe withdrawal rate is 4% you need $1.25m a year to retirement. If it is 3% you need $1.67m to get 50k a year. 

LaMonica: So it matters a lot. And the math here is pretty simple. Divide the amount you need a year to support yourself by the percentage withdrawal rate. In this case it is $50k a year divided by .04. That is how you calculate it. 

Jayamanne: The other notion that Mark mentioned is the idea that you want to maintain a real standard of living throughout retirement. When we use the word real in personal finance we mean adjusted by inflation. Because retirement can last a long time and if you have a 30 year retirement that $50k you are initially taking out of your portfolio to support your living expenses will not have the same purchasing power at the end of that retirement period. 

LaMonica: So the way this is adjusted is that you take $50k out your first year of retirement using that safe withdrawal rate and then each subsequent year that $50k goes up by inflation. So if inflation is 5% you would take out $52,5000 the next year. 

Jayamanne: And the important caveat of course is that we want to focus not necessarily on the published inflation numbers but how they affect you personally based on your own personal circumstances and spending needs.  

LaMonica: So if I ever get addicted to YoChi yogurt my personal inflation rate would be about 25% a year. 

Jayamanne: Exactly. But high-priced yogurt aside one example is housing. For instance, the last reading of inflation in Australia showed 7% growth from the prior year’s period. But the different components of consumer spending measured by the government went up different amounts. Housing costs grew 9.8% during that time. 

LaMonica: So if you are lucky enough to retire with a home you own and a paid off mortgage that portion of inflation may not impact you.  

Jayamanne: So everyone is different and please think about your own personal circumstances.  

LaMonica: Let’s get back to inflation and the impact on retirement. If you are increasing the dollar amount you take out of your portfolio every year by inflation and inflation is higher that means that more needs to come out of your portfolio all things being equal. That means your portfolio needs to be bigger. 

Jayamanne: Lets model out this scenario that we talked about earlier. You take out $50k the first year of retirement, your retirement lasts 30 years and inflation is 5%. That means that to get the same purchasing power in the 30th year of retirement you are taking out $216k. 

LaMonica: That is a huge difference. 

Jayamanne: Yes it is. If inflation was 2% over those 30 years you would be taking a little over $90k out of your portfolio after 30 years. 

LaMonica: And if we look at the aggregate withdrawals over this 30 years that a portfolio needs to support we can see the vast differences in the two inflation scenarios. In the 2% scenario the portfolio needs to support total withdrawals over 30 years of just over $2m. In the 5% inflation scenario it is almost $3.5m.  

Jayamanne: And we can take one more look at this difference by adjusting the withdrawal rate on the 5% inflation example to equal the total withdrawals of the portfolio at the 2% scenario which Mark just said equals around $2m. In that case the initial withdrawal rate would not be the 4% which was needed to generate $50k in that first year from a $1.25m portfolio. The withdrawal rate would have to be 2.9% in that initial year. 

LaMonica: And that is a huge difference in the dollar amount taken from the portfolio. Instead of living on $50k that first year the total would now be $29k. That would be a very different standard of living. 

Jayamanne: So this exercise demonstrates a simple fact about inflation and retirement. Higher inflation makes it more difficult to support a real standard of living in retirement without running out of money. It means with all things being equal the safe withdrawal rate is lower in inflationary environments which means you either need a bigger portfolio to support your retirement or a lower standard of living.  

LaMonica: And let’s spend a bit of time on a key phrase that Shani mentioned there – all things being equal. All things being equal refers to the other factors that influence when and if you will run out of money and that is the returns generated by your portfolio. We think of retirement as an event but for your portfolio you may switch from continuing to contribute to withdrawing funds at the point of retirement, but the money stays invested and you will earn a return on that money.  

Jayamanne: The higher the returns you earn the more you can take out of your portfolio. This should seem self-evident, but we need to explore what happens to returns in higher inflation environments. And we need to look at real returns or returns in excess of inflation. Because that is what counts when we discuss investing. You invest so that your money grows and what we mean by that is we want to have growth in relation to the purchasing power of what has been invested.  

LaMonica: That’s right Shani. A 10 percent return is higher than an 8 percent return. But what if I told you the 10% return was earned at a time when inflation was 5% and the 8 percent return occurred when inflation was 2%. You would take that second scenario because in real terms you are earning a 6% return instead of a 5% return. 

Jayamanne: If we go back to 1900 and look at Aussie shares, we see that they delivered a real return of 6.7% a year. But in low inflation years they delivered real returns of around 13% per year. In high inflation years they had a real return of around a half a percent a year. 

LaMonica: And those are shares which generally perform better than other types of investments. In those high inflation years precious metals – gold and silver – cash, Aussie government bonds and US treasures had negative real returns. You lost money in real terms. 

Jayamanne: So this is the double whammy of inflation. High inflation makes it hard to support higher withdrawal rates while crushing the very returns that would allow you to maintain that withdrawal rate to support a higher standard of living. 

LaMonica: And this is why there is such a focus on battling inflation. It leads to poor economic outcomes for everyone, but it crushes people in retirement. If you are still working, you would expect your wages to rise in an inflationary environment. Perhaps that raise won’t match inflation and your standard of living will go down but at least there is a mechanism to offset it a bit.  

Jayamanne: In the old retirement systems which were essentially defined benefit where you would get a government or other entity to give you a pension, inflationary times hurt retirees if those pensions were fixed. If they were indexed or matched inflation it hurt whoever was paying them out – governments for example. But now we have a defined contribution system where many of us are more and more responsible to save and invest for retirement.  

LaMonica: And this is a contributing factor to why inflation can lead to social upheaval. Most famously with the fall of the Weimar Republic and the rise of Hitler in Germany. Which is an interesting pivot point to our final topic of discussion. After World War 1 Germany was saddled with huge reparations to pay for the destruction to the allied counties.  

Jayamanne: Another history lesson mate 

LaMonica: This will make sense I promise. This massive amount of debt was one reason that the Weimar republic as the democratic government in Germany was known let inflation get out of control. They just didn’t really have any other way to pay all the debt they took on to try and function as a country while paying off the allies. And one of the only parties that benefit from high inflation is people or companies or governments that hold massive amounts of debt. 

Jayamanne: If you have a bunch of money in your bank account inflation is really bad because you can buy less with that money. But if you have a massive amount of debt then inflation will make that debt worth less. Which is good for you. 

LaMonica: Not so great for the person who loaned you the money – hence the negative returns on government bonds in inflationary times. 

Jayamanne: There is one caveat to this of course. The debt needs to be fixed rate because if that interest rate keeps changing it doesn’t do you much good. But inflation is positive if you owe money. In real terms you have less to pay off and we often hear about inflating your way out of debt. 

LaMonica: And now we are delving a bit into conspiracy theories which will get Shani excited. 

Jayamanne: I’m into crime conspiracy theories not inflation related ones. 

LaMonica: Well to some people this is more exciting than who killed Jon Benet Ramsey. This conspiracy theory goes something like this. As we talked about in our last market update, we’ve had an explosion of debt. A great deal of that debt is government debt. The conspiracy theory basically says that governments will let inflation run because they have no other way of paying off their debt so they will inflate it away. 

Jayamanne: And do you believe in this conspiracy theory? 

LaMonica: I mean I don’t exactly, but I will say we are starting to see cracks in the solidarity between central banks and governments when it comes to fighting inflation. Many of the things that the fight against inflation involve – slowing economic growth and inflicting economic pain are not things that governments trying to get votes want to be associated with.  

Jayamanne: And we’ve started seeing governments spending more while central banks raise interest rates. Spending more is of course inflationary while raising interest rates is deflationary. And we saw this back in the 70s with Nixon in the US where the fights against inflation were ultimately weak and ineffectual with one reason being Nixon’s opposition to it. 

LaMonica: To end this episode we are going to try and offer some solutions to people nearing or in retirement to deal with this issue we discussed. If you are approaching retirement there are a couple things to do. None of them particularly appealing. 

Jayamanne: The first is to save more. Building up your portfolio allows you to deal with lower withdrawal rates and / or a lower return environment. The second of course is to delay retirement. That gives you more time to save and delays when you tap into your portfolio.  

LaMonica: And if you are already in retirement there are a couple things you can do. One is obviously cut back on your spending and the increases you take for inflation. Spend some time focused on your personal inflation rate and how price increases as measured by the government really impact you. 

Jayamanne: The second piece of advice is make sure you aren’t getting too conservative in your portfolio. While we talked about real share market returns being lower in an inflationary environment remember that asset classes like cash and fixed interest were actually negative. Getting too conservative could be a real issue. 

LaMonica: And also potentially looking for inflation hedges in your portfolio. We could do a whole episode on this, but commodities typically perform well in an inflationary environment, companies that have moats or sustainable competitive advantages that allow them to do decently in the shifting business and consumer spending patterns that often occur during inflation and also finding companies that have built in inflation hedges in contracts they have with customers like many infrastructure companies have. 

So maybe not the most cheery end to the episode but one way to protect yourself against inflation is to win a free Amazon echo dot, but I guess that only counts if you were going to purchase one. So if you would like to enter that competition, send those comments along to my email address and hopefully you will soon be able to ask when Shani is going on vacation.