When Higher Inflation Meets Your Withdrawal Rate

“I think somewhere in [the] 4.75%, 5% [range] is probably going to be OK.”

William Bengen, the creator of the 4% guideline for in-retirement withdrawals, made that comment in a conversation with Michael Kitces late in 2020.

Why the higher withdrawal rate? Low inflation.

Bengen’s initial assumptions were that inflation would run close to its historical norm of 3%. But given the ultralow levels of inflation that prevailed for much of the past decade, his view was that a higher starting withdrawal, combined with smaller annual adjustments thereafter, would likely be maintainable. But he added a caveat: “We won’t know for 30 years, so I can safely say that in an interview.”

Fast-forward two years and high inflation is indeed upon us; the most recent inflation rate reading was more sluggish than expected, but still high relative to historic norms. Bengen himself has worried about the implication of recently higher prices for retiree spending. In a discussion on The Long View podcast late last year, Bengen said, “I’m hoping that the 4.7% rate I developed recently holds, but there’s possibility it might not if inflation becomes sticky and becomes like a 1970s’ kind of phenomenon.”

The possibility—but not the certainty—of higher inflation embellishes the case for taking a more conservative approach to in-retirement withdrawals than what may have been warranted before, a topic we discussed in depth in a research paper published late last year. It also argues for taking a close look at other tools at your disposal to ensure that a spike in inflation doesn’t imperil your portfolio’s ability to last over your in-retirement time horizon.

You Win Some, You Lose Some

Before delving into whether and how retirees should adjust their withdrawals for higher inflation, it’s helpful to think through the interplay between inflation, investment returns, and withdrawals. Inflation is especially meaningful for retirees because the money that they’re withdrawing from their portfolios isn’t inherently getting an inflation adjustment. That stands in contrast to workers, who usually receive cost-of-living increases over time. Investment returns are also critical because retirees aren’t typically adding new money to their accounts.

As it happens, people who have retired over the past decade have been extraordinarily lucky with both inflation and investment returns: Not only have stock and bond returns been strong, but inflation has been exceedingly low, too. That means retirees’ portfolios have been enlarged at the same time they’ve been able to maintain their standards of living without having to jack up their withdrawals.

Other decades have featured one but not both of these positives: In the 1980s, for example, inflation averaged more than 5% and bonds were no great shakes, but the S&P 500 returned nearly 12% on an annualized basis during the decade. The 2000s, meanwhile, featured so-so equity market returns but inflation didn’t run a lot higher than its historical averages.

The decades ahead may feature a similarly bifurcated environment, where retirees win on one side of the ledger but perhaps not both. Or perhaps they’ll win on both sides again. The truly worrisome scenario is if retirees encounter weak investment returns at the same time that they have to spend significantly more to maintain their standards of living because inflation has gone up. While such periods haven’t been particularly common in modern market history, they’re not without precedent.

The early 1970s were one such environment. Bengen himself called it "The Big Bang." Inflation shot up by 6% in 1973, while the S&P 500 dropped 15%. The year 1974 was even worse, featuring an inflation rate of more than 11% and stock losses of 26%. That was a worst-of-all-worlds scenario for retirees, necessitating higher withdrawals at the same time the market was down. The small silver lining was that interest rates, and in turn yields on fixed-rate investments, were higher, but inflation gobbled up every bit of that interest.

Investors are clearly concerned about a repeat. In a recent survey by Fidelity Investments, 71% of respondents said they were concerned about the implications of inflation for their retirement plans, and 31% said they weren't sure how to keep up with inflation.

Implications for Withdrawals

What are the implications for withdrawal rates? It stands to reason that retirees concerned about sustained high inflation during their retirement years ought to err on the side of conservatism with respect to starting withdrawals. That provides a level of protection if that starting amount ends up getting ratcheted up meaningfully to account for inflation.

The good news for today’s retirees is that even though inflation could be a headwind, at least in the early years of their retirements, the lower starting equity valuations and especially higher bond yields that prevail today portend better investment results than when we issued our withdrawal rate research late last year.

John Rekenthaler also points out that when the inflation occurs in retirement is crucial. Like a weak market environment, inflation in the early years of retirement is especially harmful. That’s because higher spending early in retirement builds upon itself and leaves less of the portfolio in place to grow throughout the retiree’s spending horizon.

What about the oft-cited wisdom to stay flexible about withdrawals, taking more in buoyant market environments and less when the portfolio is down? That’s a bit of a head-scratcher in the context of inflation, especially if higher prices coincide with a period of market weakness, much as we’ve seen so far in 2022. It’s true that much research over the past few decades points to the value of curtailing withdrawals in market downturns, because it leaves more of the portfolio in place to recover when the market eventually does and improves the portfolio’s long-run success. But what if an inflationary environment presents itself at the same time the portfolio is down? The retiree might have been planning to take less in market downturns, but higher prices could make that difficult by reducing the purchasing power of those lower withdrawal amounts. That’s less of a risk factor for more-affluent retirees, for whom cutting spending might mean taking two high-cost vacations a year instead of four. But for retirees without a lot of wiggle room in their budgets, cutting expenses could be a lot more difficult because it might affect outlays for basic living expenses.

Other Levers

On the other hand, lower-income retirees will have a higher share of their working incomes replaced by Social Security than higher-income workers, and Social Security income is inflation-adjusted. That emphasizes the importance of thinking holistically about the retirement plan in the context of inflation rather than focusing exclusively on portfolio withdrawals. That includes maximizing cash flows from income sources that are themselves inflation-adjusted, such as Social Security. One of the reasons that retirement planners argue for healthy people to delay Social Security is not just the larger benefit that comes with waiting, but that the larger benefit is also inflation-adjusted. Annuities might be another piece of the equation, but unfortunately, very few annuities offer inflation protection today, and to the extent that they do, the additional protection is costly.

Another idea is to reduce your spending plan’s vulnerability to higher inflation. The decision about whether to buy a home or rent one is obviously about much more than inflation, but a major financial benefit of homeownership is not having such a big expense buffeted around by inflation. The CPI-U and CPI-E figures discussed in my recent article about personal inflation rates assume outlays of 42% and 47%, respectively, for housing. To the extent that retirees can fix at least a portion of their housing expenses, that reduces their vulnerability to inflation in that part of their budgets. (Of course, housing-related line items like utilities and property taxes could still inflate.)

Finally, your investment portfolio should play a role in guarding against inflation to help ensure that your purchasing power isn’t gobbled up by higher expenses during your retirement years. That’s why my Model Bucket Portfolios include ample exposure to assets that have some ability to hedge against or outearn inflation over time. Treasury Inflation-Protected Securities fit into the former camp and equities into the latter.

A version of this article previously appeared on April 5, 2022.