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Inflation. It’s hard to find a headline that doesn’t mention it these days. And with the Consumer Price Index (CPI) up over 8% year over year, everyone is feeling the sting of higher prices. But for those nearing or in retirement already, the specter of inflation could be more terrifying than for younger Americans. Without rising wages to offset higher prices, some Americans are facing the prospect of a lean retirement. Popular real estate investor Graham Stephan breaks the inflation threat into three categories.
1. The vanishing 4% rule
One of the rules of thumb in retirement planning is the 4% rule, and is referenced by FIRE folks alongside traditional retirees. The rule states that, given a well-diversified portfolio, a retiree can withdraw 4% of their assets annually, adjusted for inflation, without running out of money.
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One of the troubles with the 4% rule is the assumption of diversification. In the original paper by advisor William Bengen, a portfolio of 60% stocks and 40% bonds was studied. This portfolio would capture the upside of equities while hedging against downside risk with bonds. Unfortunately, in an inflationary environment with frequent Fed rate hikes, bonds are facing similar headwinds to stocks, making them far from the perfect hedge.
Another problem with the 4% rule lies in the size of withdrawals. Withdrawals are an annual 4% adjusted for inflation, which in a normal market sits around 2%. In an inflationary environment where rates push near 10%, a retiree’s withdrawal rate could be substantially higher not only in the current year, but for the remainder of their retirement.
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2. Unequal inflation
The Consumer Price Index is a popular way to calculate inflation rates year over year. In fact, that index gave us the frequently quoted inflation rate we talk about today. However, don’t miss that the CPI is a benchmark made up of many different inflation rates, some more dangerous to certain groups than others.
Within the CPI lie a variety of components including housing, transportation, education, and more. Because each of these rates varies, it is important to note that each American is affected by inflation slightly differently. A college student may be more susceptible to the rising cost of education, while a young professional looking to buy a home may be hit harder by rising housing costs.
In 2022, costs relating to food and medical care soared relative to the broader Consumer Price Index. As Graham points out, the cost of bread and eggs jumped in price 16% and 39% respectively, while medical care is up 5.6% in the last year. Notably, retirees may miss out on boons such as the dropping price of gas, given that they drive less than the average American.
3. Underperforming returns
When it comes to preserving standards of living, retirees have fewer options than most Americans. Because they are no longer working, a retiree must rely exclusively on their investment returns to support their living expenses. Unfortunately, the markets aren’t in the greatest spot at the moment.
While the previous century saw bond and stock investments beating inflation rates, that trend could be in trouble in the coming years. The broad-based S&P 500 is down on the year by nearly 24%, while the bond market is in turmoil at home and abroad. Protecting your buying power may be difficult to do when markets aren’t showing positive returns.
When it comes to retirement, a large variety of factors can upend your plan. The 4% rule, highly regarded for nearly 30 years, may be proving unsustainable in current market conditions. Inflation is hitting retirees harder than many Americans, while markets are providing no escape for the time being. In the words of Graham Stephan, now’s a good time for retirees to be flexible.
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