How Much Does Sequence of Inflation Matter?

On this episode of The Long View, Jamie Hopkins, professor, author of Rewirement: Rewiring The Way You Think About Retirement, and managing partner of Wealth Solutions at Carson Wealth, discusses financial freedom, inflation, and how to set up your retirement for success.

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

Retirement and Sequence Risk

Benz: Wanted to go back to the topic of retirement planning, which is where a lot of your expertise is, and your previous book was about retirement planning. This has been a really challenging year for people approaching and in retirement. So, the question is, Is this year the epitome of what we are thinking about and talking about when we’re talking about sequence risk?

Hopkins: It really might be. This is probably, basically one of the worst years ever when we talk about bond performance, especially to start the year and market performance together. We hadn’t really seen that. That was a scary year. There are some benefits. I try to look at the positives for retirees, too. I think one of the positives that I saw this year, which wasn’t discussed a whole lot, but actually, if you track that CPI-E number, which is the Consumer Price Index Experimental to track our senior spending, that actually trailed a decent amount under the CPI-W numbers, which are often more of the ones that we adjust inflation for, for things like Social Security.

If you actually look at those two, I think it was almost a percent higher at the third quarter on the CPI-W, meaning that retirees actually got a benefit from higher inflation elsewhere this year, which is usually not the case. We almost always have, for about a decade now, been higher on the senior side due to healthcare and healthcare lagged other areas this past year. So, there’s a little bit of a silver lining out there. That’s a small benefit for seniors. Seniors tend to own more home equity but with less debt attached to it than younger people, which is actually a double win there, too. They’re probably not buying new houses at the same levels, and they have more home equity, which appreciated a lot, which drove up a lot of the inflation numbers. And if you actually look the last year on, I think total net worth of Americans, I think we’re still up a bit. It’s not as bad as you might think with some of the headline market and bond performance at the beginning half of the year.

And then, lastly, if we can stay the course this year, it’s been pretty normal in, midterm election years we go back to 1952, and it’s like an average of what 17%, 18% entry or pull-down average early September since World War II. And then, you go out a year out from that and it’s been, on average, up about 20 some percent a year out from that entry or pullback date. It gets pretty normal in midterm election years to have the market side, I think with the bond portion occurring at the same time, really, really uncommon. It’s basically the worst. And that’s scary to people, high inflation. So, you wrap all that together. And then, I just try to balance it with some of the other pieces. As home prices are up, most retirees probably already locked in good rates, and total net worth might have gone up and might have actually benefited from Social Security adjustments this last year if you’re a retiree. So, it is not all bad news. I try to put some on both sides. But it’s also real that it’s a scary year to be a year or two out from retirement, or one or two, three years into retirement.

How Much Does Sequence of Inflation Matter?

Ptak: One question we’ve asked ourselves, and one we’ve also put to previous guests, including Wade Pfau and William Bengen, is how much sequence of inflation matters? What’s your take on that?

Hopkins: Sequence of inflation to me matters a lot. Wade and I have talked about that recently. The reason is a high inflation early in retirement or life, I guess possibly too, permanently increases your cost over the life. You would rather have high inflation in the last couple years of your life than the first couple of years of retirement, because you’re then—let’s say, we even get back to 3% inflation. We’re wrapping 3% on an already higher starting number. So, that is a risk.

I think the one flip side of the inflation numbers are, we’re not very good at predicting any of that. Inflation is scary. Even where we are today is lower than what the entire 1970s were as a decade, like average. It’s high in comparison to where we have been. It is lower than a lot of Europe. I used to bring up when I taught in the RICP, Brazil I think in 1990 or 1991 had 32,000% inflation in one year, and my joke was, you’d want to pay for dinner before rather than after. But we’re not experiencing things like that. We’re experiencing high inflation for us, but we are not experiencing yet—and maybe inflation has already started to peak here, but we’re not experiencing—the Netherlands in Europe, their inflation is higher. We’re not experiencing the worst inflation we’ve ever seen in the history of the world. But it does decrease, especially retirees who can’t move their income as much, like they really do see that decline in purchasing power over time, which I usually say, inflation is not for retirees usually a one or two-year problem; it’s a 30-year problem that that compounding over time is the really scary part and does it end up depleting somebody’s purchasing power in 15, 20, 25 years to the point where they can’t live the life they want to live?

How Should Investors Protect Their Portfolio From Inflation?

Benz: Sticking with that point of preserving purchasing power, that’s really come up this year where we’ve seen Treasury Inflation-Protected Securities fall in price even as they deliver some inflation adjustments. How should people approach inflation-protecting their portfolios, and maybe you can take it by young accumulators, how should they think about it as well as people who are in or nearing retirement?

Hopkins: It’s a great question, and I do think even to your question/statement, it depends. And I don’t believe that there is 100% accurate answer to this question, and it goes back to my point before is, we’re not great at predicting inflation numbers just in general. I think you go back like two years ago I don’t think very many people had a good forecast into inflation. It’s pretty hard to predict it. And we’ve talked about different areas of the world being good protection. Generally speaking, equity markets have performed well as inflation hedges in the long term. They don’t always align year to year, so like this year, it wouldn’t be a great inflation hedge. But if we go out over a 10-year period, will it work? Possibly. It has historically worked pretty well. TIPS, Dr. Michael Finke will argue that they’re pretty good inflationary protection mechanisms, and maybe not for everybody.

There are some products out there that will give you inflation protection. And I say some, and I put an asterisk here if you saw me in air quotes. They tend to be pretty expensive to purchase that whether you’re talking about a life or annuity product. I don’t know that in those cases they actually work all that well. I just don’t know that there’s enough actual research going back on the historical performance on them to demonstrate it one way or the other. But there’s some benefit there. When you think about retirees, to me, I still push this as pushing out Social Security is a good inflationary protection mechanism. The more you push out, the bigger bucket you have. And while again it is not perfect, it’s not a one-to-one inflationary adjustment, the third quarter to third-quarter adjustment, this year was probably better than what seniors saw in actual inflation. In a lot of other years, it’s been worse and it’s always trailing a little bit, but that does help a lot. And it goes to the core that Social Security has worked fairly well in that regard of keeping seniors out of poverty.

When we’re working, I think the bigger thing is focusing on reinvesting back into yourself and your ability to move your own income up, and not everybody can do that. And I want to acknowledge that. But if you’re in one of those situations where you can drive that, that’s going to be your—human capital asset for younger individuals is going to be your big benefit to offsetting inflation to some degree is that you can earn more money over time, and reality is, sometimes you might need to switch jobs. And we talked about that briefly earlier. I didn’t know this was going to be a call where I was telling everybody go find new jobs. But we saw that occur this last year and a half—the great resignation or whatever we want to call it—seems to have slowed down a bit. But I think that some of that was a reality, is that places were willing to pay more, which was also driving some of the inflation, and that people were looking around with costs of things and saying “I will make a move based off of finances and how much money I’m earning.” And that’s a reasonable decision to make. A lot of research shows that you do need to switch jobs in that five-year gap, to really keep pace with your total earning potential and that loyalty to companies doesn’t always pay off.

Is the 4% Guideline Still a Good Benchmark?

Ptak: You studied safe withdrawal rates for retirement in some detail, and you write about the topic in the book. How do you think people should figure out how much they can safely withdraw in retirement? Is the 4% guideline still a good benchmark in your opinion?

Hopkins: The 4%, well, I’m glad that we called it a guideline and not a rule. It’s probably my biggest pet peeve is that we refer to it as a rule a lot. I don’t think that there’s a safe withdrawal rate, meaning that like it’s 100% safe. I think we can be pretty confident but not 100%. Even the research of 4% didn’t say that it was 100% sure and safe. It just worked in the past. I think that things like whether it’s 4% or 2.75% or 3%, or is it 5%, all of that depends on what the situation looks like. I remember seeing some article one time that was saying, if you swapped out this and put this in, the 4% rule doesn’t work. And I was like, well, it’s not a rule and it wasn’t based on that asset allocation. So, of course, it wouldn’t work. They wouldn’t expect it to work. There’s also research that shows if you incorporate home equity into the distribution side upfront, market drops, borrow from your home, you might be able to find a “safe withdrawal rate” at closer to 6%. If we start thinking holistically about our assets and how we’re going to use them and what flexibility we’re going to allow for year to year, we can come up with a much more I think plausible distribution strategy for ourselves. I don’t think that there’s anything wrong with the research around safe withdrawal rates because I do think benchmarking somewhere gives us some guidelines. Maybe it’s 2.75%, maybe it’s 4%, not really sure. But if we’re at 8%, we probably know that we don’t have a sustainable withdrawal rate. If we’re at like 1.75%, we’re probably underspending. And so, somewhere in that range we can start to get comfortable with things.

And the other part about this is the reality of the world is when the markets drop, when the economy is worse, people cut back their spending, they don’t do as much. We don’t live in a static spending environment. No retiree lives like that. We live in a dynamic spending environment. Any of those models don’t align to reality. We have to understand that if we allow for flexibility in our spending, in our expenses in retirement, we can increase our average withdrawal rate that will make it because we will cut back in bad years. And Americans are incredibly resilient. An amazing thing about us is we are incredibly resilient. We find ways to get through troubling times. People find ways to get through retirement. They find ways to cut back and survive and cut costs here and do other things over here. And it’s one of the statements I make, I don’t think we’re in a retirement crisis. I think individuals have retirement crises, but I don’t think as a country we are because of that fact that Americans find a way to get by, and I think we will continue to be. It doesn’t mean that it’s as good as it could be, but we will continue to do that. And I do think that safe withdrawal rates are a good guideline and starting point, so we have some parameters about what may work, or what may not work, but they shouldn’t be treated as some type of rule or Holy Grail.