Is Inflation Another Form of Sequencing Risk?

On this episode of The Long View, Wade Pfau, a professor of retirement income and author, shares his thoughts on inflation, rising interest rates, and his well-known retirement research.

Here are a few excerpts from Pfau’s conversation with Morningstar’s Christine Benz and Jeff Ptak:

Inflation and Retirement Risk Factors

Ptak: We’re currently seeing inflation at its highest level since the 1980s, as you know. Does inflation hit retirees harder than it does the general population? Or is it situation-dependent?

Pfau: I think it’s situation-dependent, and you could say, yes, inflation hits retirees harder because often to the extent that salaries grow with inflation, you kind of have a built-in inflation hedge when you’re working. Now, I recognize not everyone’s salary may be keeping up with inflation right now, but at least there’s more potential to have a hedge for inflation when you’re still working that you lose in retirement. But then, at the same time, the answer might partly be no, because plenty of research now indicates that most retirees’ spending needs won’t fully keep up with inflation throughout retirement. And so, even if their inflation is high, they may have a little bit of flexibility there because they’re naturally going to spend less as they age to not need the full inflation protection that people might need more during their working years. So, it’s definitely situation-dependent. But it’s kind of a toss-up— it hits retirees hard; it hits nonretirees hard. It’s a tough situation for everyone.

Inflation in Early Retirement

Benz: When we had William Bengen on the podcast last year, he likened the timing of inflation to another form of sequencing risk. Basically, if inflation occurs early on in your retirement, that’s really bad, because spending tends to build off of those higher levels. Do you share that concern?

Pfau: I do. And this is something I’ve pondered for a long time. I’ve heard about this idea of the sequence of inflation risk. And it seemed like it shouldn’t exist because most of the basic research about spending rates in retirement just uses the real returns. So, it takes inflation out of the analysis. And in that regard, it seems like inflation shouldn’t matter. But it seems like it does. And I guess this idea of thinking about sequence risks really applies, because if there’s a 10% inflation rate in the first year of retirement and then it gets back to normal afterward, say, you’ve permanently raised every future expense — every future year of spending has been impacted by that first-year inflation rate. So, it would have a bigger impact on the retirement plan compared to, say, staying maybe 20 years into retirement, there’s a big inflation experience, that’s only going to impact a lesser number of years of spending.

So, in that regard, it seems like it’s important. And certainly, in the historical data, the worst-case spending scenarios happened at high inflation periods in the late 1960s, where those retirements began at a time with high inflation and then especially going throughout the 1970′s high inflation. Whereas in more recent years, I used to have a lot of worry around people who retired around the year 2000 just because of where the markets were for their retirements. But they have low inflation and that does seem to be a saving grace that even with markets that aren’t performing all that well, if inflation is low, it’s not putting as much pressure on the spending need. We’re now getting into this perfect storm again, where inflation is higher, markets are volatile, there’s been heavy losses, and so forth. And yes, I do think inflation is important and it’s still hard to fully articulate. But yes, it does seem to me that there is this idea of a sequence of inflation risk, and so Bill Bengen was definitely talking about something real in that low inflation can go a long way toward helping with a portfolio in retirement spending, and when you have high inflation again, it’s a concern.

Can You Insulate Your Retirement Account From Inflation?

Ptak: Something that’s striking is that higher inflation would seem to complicate planning for people with all different retirement income styles, albeit not equally. But the safety-first people, for example, may not be generating income that’s completely insulated from inflation. Are they especially vulnerable in a high inflationary environment? For instance, if they’re getting a good share of their portfolio income from a fixed annuity that doesn’t include an adequate inflation adjustment?

Pfau: They could be. So, really, the main tools people have for dealing with inflation are the TIPS and I Bonds, inflation-adjusted bonds, or equities, and it’s, of course, not a perfect hedge, but the hope that over time the earnings and revenue of businesses will grow with inflation and therefore, stocks will keep up with inflation. So, beyond that, traditional bonds do not work well with inflation. Fixed annuities are not going to work well. But if it’s just simply a comparison of like Treasury bonds versus fixed annuities with providing lifetime income, the fixed annuities should always work better than the traditional bonds just because they can meet a spending goal with less assets, and that’s really getting into the strategy of thinking about annuities as a bond alternative. If I can put less assets into an annuity than I need with bonds to meet the same sort of lifetime spending need, that frees up more assets to remain invested for upside and hoping that stocks will keep pace with inflation and so forth. So, it’s not obvious that a safety-first approach would underperform or would be harmed more by inflation, certainly not when compared with traditional bonds. But when you have approaches that do use more of an inflation-protected bond approach, that would have obvious benefits in a higher inflation environment for sure.

Worried About Risk in Retirement?

Benz: Your book includes a comprehensive catalog of risk factors that people face with their retirements, and some of them like inflation and longevity risk and sequencing risk, which we’ve kind of touched on already, will probably be well known to people listening. But we hear less about some of the other risk factors that you talked about. Can you discuss some of the risk factors that are less well known that you think are worth considering as people approach retirement planning?

Pfau: Sure, and I generally organize retirement risks as either kind of longevity risk, market risk, and then spending shocks. The way I define a spending shock is, you have to spend more than you anticipated in your retirement budget. So, inflation could be a market risk, or it could be an example of a spending shock if you get hit by higher-than-expected inflation and therefore have to spend more. Divorce can be a huge spending shock when you’re trying to account for dividing assets to create two separate households, each household not wanting to cut the spending in half, it can lead to a more expensive overall environment. Family responsibilities of having to help raise grandchildren or support adult children who may not be able to develop the careers they’d hoped for, and so forth. That can be a spending shock.

There’s definitely the idea of public policy risk. We have the rules — the tax rules, Social Security rules, and so forth—and those rules can be changed, and they can be changed in ways that lead to having to either spend more than anticipated, higher taxes and so forth, or just not having the assets anticipated, like if Social Security benefits receive some reduction or something along those lines. There’s frailty and cognitive decline. If cognitive decline causes somebody to make financial mistakes, that ultimately leads them to have to spend more, and that could be as something as simple as subscribing to the same magazine multiple times. Or of course, it could be just there’s no limit on what that type of risk could do in terms of the spend down of assets in unanticipated ways. And then, also retirement housing, and people have to think about with the gradual decline people experience physically having to outsource some tasks that they may have done for themselves, such as mowing the grass and so forth, at some point, would raise the expenses. Needing to move for health-related reasons could raise the expenses. Those are some examples that I think really kind of highlight the potential range of spending shocks.