How Inflation Changes Your Safe Withdrawal Rate

On this episode of The Long View, Morningstar’s Christine Benz, John Rekenthaler, and Jeff Ptak discuss the recent study they published, “The State of Retirement Income.”

Here are a few excepts from Benz and Rekenthaler’s conversation with Ptak.

The State of Retirement Income

Ptak: Christine, this is the second time we’ve run the study, the first one being in 2021. What are the most notable changes from the findings in last year’s study?

Benz: We assumed a 50% stock, 50% fixed-income portfolio. We assumed a 30-year time horizon. And we assumed that the retiree was aiming for a 90% success rate—in other words, a 90% chance that he or she wouldn’t outlive his or her assets over that 30-year time horizon. And importantly, we assumed what we have called a fixed real withdrawal system. So, we’re assuming that the retiree withdraws X percentage in year one of retirement and then inflation adjusts that dollar amount thereafter, which is the convention for thinking about safe withdrawal rates. And I know we’re going to discuss whether that’s the right way to approach it.

When we compare this year’s result versus last year’s, last year [the withdrawal rate] was 3.3%, a very low number, certainly relative to that 4.0% guideline. This year, it was 3.8% for that base case. And the key reason is that the return inputs are higher this year, in part because the market has been really difficult. So, we embedded higher bond returns. That’s a big factor in the mix. The bond returns we used this year—this is a 30-year forecast, which we received from our colleagues in Morningstar Investment Management—the assumption is in the neighborhood of 5% for high-quality fixed income. And then, for equities, it’s in the neighborhood of—depending on the subasset class—between 9% and 12%. And those got a big lift from the numbers we used last year. So, last year, we assumed 3% 30-year fixed-income returns and equity returns as low as 6% for core categories, like U.S. large growth. The higher return assumptions for both stocks and bonds gave that baseline, base-case return assumption, and in turn, withdrawal rate assumption, a nice lift from last year.

How Should Retirees Balance Stocks and Bonds?

Ptak: Christine, one interesting finding was that the starting safe withdrawal rate for the fixed real approach that you’ve been describing, it didn’t increase even if you tilted the portfolio more toward stocks. Why do you think that is, and what do you think the implications are for retirees who are thinking about how to calibrate that stocks/bonds mix in their retirement funds?

Benz: I remember when the three of us initially embarked on this research, and we came out with that 3.3% number last year. And I remember my gut response was like, well, let’s dial up the equity exposure and see what happens. And the reason that the lower equity weightings actually support reasonably high withdrawal rates is just that bond returns are much less variable than equity returns. We’re embedding standard-deviation assumptions, and the standard deviation for bonds is just so much lower than is the case for equities. So, that’s the major reason. If we’re looking at that 3.8% starting withdrawal rate for this year, one thing we found is that you could dial equity exposure all the way down to 30% of assets and still be able to use a 3.8% number as a starting safe withdrawal rate.

Rekenthaler: To add to what Christine said, I think one thing that will come through this discussion is, we’re talking about a single number—in this case, this 3.8% number that’s moved up from 3.3%. And that’s useful. It shows directionally up 0.5%, and I think that’s very useful and accurate information. But there’s a lot of complexity that’s built into this estimate that underlies this. And one thing to be said, or an additional matter to discuss with this is, we’re running trials—in this case, 1,000 different simulations go into this estimate of a 90% success rate. And when you push up, you add more equities, you’re going to get more trials, circumstances that the coin flips in the wrong direction and you have a sequence of bad returns, and that is going to affect when you’re trying to have a 90% success rate, which is a pretty high success rate. You’re trying to succeed nine times out of 10. And that’s where the volatility, the extra volatility that stocks have, really damages chances for a high percentage of a safe withdrawal rate.

But one thing that should be noted is, for the median case, if investment returns don’t go particularly badly or even particularly well, but average, you do have a much higher ending balance with equities than you do with more conservative portfolios. There’s rarely, or very often, not a single best answer when we’re doing this work. It depends on what you’re looking for. And we have defined a 90% success rate with a fixed system, where the investor must achieve 90% success and there are no exceptions in the spending plan allowed. And in that case, it calls for a conservative portfolio given those constraints. But somebody is willing to be more flexible and is, in particular, interested in potentially having a higher balance at the end, and leaving money to heirs or to charity, would certainly wish to consider a higher stock allocation.

Ptak: Exactly. Our definition of success itself can have some bearing on what the “safe withdrawal rate” is.

Rekenthaler: That’s true for anybody, anywhere that is specifying what a retirement plan can be. There are always assumptions in there often not discussed. I think we’re getting our assumptions out front, at least, that really affects the final counsel that’s given.

Inflation and Retirement

Ptak: I want to return to inflation. Christine, in last year’s study, we assumed inflation would average around 2% per year over the following three decades, but it’s run, obviously, quite a bit above the forecast over the past year. Given that, how did we factor inflation into this year’s study?

Benz: As with the return assumptions, we received the inflation forecast from our colleagues in Morningstar Investment Management. And so, you’re right, Jeff, that when we got the 30-year forecast from them this year, it was substantially higher, 2.8% versus 2.2%, which is what we used last time around. But I think people might be surprised. Inflation, as we talked today, is what, 7.0% or so. But I think that 2.8% number assumes that inflation will level out to a more normal level in the years and certainly in the decades ahead.

Rekenthaler: Quietly, core inflation has averaged 3.0% the last two months. So, we’ll see if that continues. But actually, it has subsided to that level over the last two months or so. But clearly, with the inflation estimate—it’s a 30-year estimate—that’s a very long time period. And the belief is that the Federal Reserve will be quite vigilant and not permit a 7% inflation rate for sustained period of time.

How Does Inflation Change Your Safe Withdrawal Rate?

Ptak: John, how would this starting safe withdrawal rate change if we held everything else constant—so, market returns constant, but assumed that inflation would be, say, twice as high as what we’ve projected? That’s not real world, obviously, because inflation and market returns, there’s interplay there. But under those simplistic assumptions, do we know how the starting safe withdrawal rate would change?

Rekenthaler: We do. It’d be a disaster. You’d drop from 3.8% to 2.6%. You’d be at 2.6%. I should point out, we have not experienced in the United States a 30-year period like that. Because as you state, when inflation rises, bond yields adjust, they go higher. If inflation were 5.6%—which is what would happen if you double our rate—bond yields would rise and the nominal return on bonds would surely be higher than the 5% that we have projected for that 30-year. And stock returns would rise too, because inflation seeps into stock returns as well. We saw that in the 1970s. So, I don’t think that would occur. But if it did occur, yeah, spend a whole lot less.