Christine Benz: It’s really important to be mindful about inflation and to take steps to protect against inflation in the plan. This is a quote that I pulled from a conversation that Jeff Ptak and I had with Wade Pfau—I mentioned Wade just a few minutes ago—where he pointed out that inflation tends to build upon itself, and that can be a real negative for people embarking on retirement. So, he says, if there’s a 10% inflation rate in the first year of retirement, and then it gets back to normal afterward, every future year of spending has been impacted by that first-year inflation rate. I think that’s such a thought-provoking point, especially right now. The idea is that even if the inflation rate gets back to normal, retiree spending will still be at that elevated level, even though that spending will be inflating at perhaps a smaller rate going forward. So, that’s just one of several reasons why inflation can be a big deal in retirement. If it occurs early on in retirement, it builds upon itself, as we just outlined in that Wade Pfau quote.
Why Inflation Can Be a Big Deal in Retirement
Another issue is that older adults tend to spend more on certain categories, where when we look over history, they may be inflating more quickly than the general inflation rate, and the main one there is healthcare, that we know that older adults do spend more on healthcare than the general population, and we also know when we look back on historical inflation, healthcare inflation has to historically run higher than the general inflation rate. So, that’s another risk factor for older adults from the standpoint of inflation.
Another factor is that retirees, because they’re withdrawing a portion of their portfolios to pay for their ongoing living expenses, don’t have the luxury that working folks have of getting those cost-of-living adjustments automatically in their paychecks. They may see some cost-of-living increase, especially if they’re receiving Social Security. But for the portion of their portfolios that they’re relying on to supply their living expenses, well, they’re not getting any sort of automatic inflation increased there. That’s why it’s really important to make sure that that portfolio is at least somewhat insulated against cost-of-living increases.
Another issue in the mix is that inflation is the natural enemy of anything that has a fixed payout. Whether it’s a bond that you might buy and hold to maturity or a CD or some sort of a fixed annuity that you’ve purchased, that if inflation runs high as you are taking income from that product, you will find that high inflation will gobble up more of it. It’s just the nature of anything with a fixed payout—that you want to be very careful and mindful of inflation. And then, finally, inherently, more conservative portfolios that lean more toward bonds and cash as is generally typical of older adults means that they have lower return potential and that means that inflation takes a bigger bite out of the return. So, this is just a series of reasons why it’s worth thinking hard about how your total plan is protected against inflation.
Inflation Protection: A Harder Problem
The tricky part is that actually insulating that portfolio and plan is a little bit more difficult. So, at the portfolio level, you’d want to think about a few key categories. Treasury Inflation-Protected Securities, and I tend to like shorter-term Treasury Inflation-Protected Securities, I Bonds, the breakout sexy category of 2022, is another category to consider bringing into your retirement portfolio. The idea is that you have explicit inflation protection for the safe portion of your portfolio with these types of products. How much inflation protection I think does depend on the individual, but when I look at the recommendations from my colleagues in Morningstar Investment Management, they typically recommend TIPS and I Bond allocations in the range of 25% to 30% of the fixed-income portfolio. So, I think that’s a good starting point as you’re thinking about how much to allocate to them.
Stocks are by no means a direct inflation hedge, and we certainly saw that on stark display last year when we saw stocks go down even as inflation went up. But over very long periods of time, if we have a sufficiently long time horizon, we know that stocks really more than any other major asset category have the best long-run shot at beating inflation, which again gets back to the value of balance—of having safe securities in your portfolio but also having growth-oriented securities in your portfolio to help beat back inflation. So, those are things to consider at the portfolio level.
At the plan level, there are a couple of strategies to consider. One is delaying Social Security, and the key reason is that—and many of you have heard that you receive an enhanced return for delaying—this is especially valuable if you think you’ll have a longer-than-average life expectancy or if you are making Social Security claiming decisions on behalf of a younger spouse. So, you receive an enhanced return for delaying, but you also receive the inflation adjustments that you would have received if you are already taking Social Security payments prior to your eventual claiming date. So, your higher enhanced return is also inflation-adjusted along the way.
And then, it’s also valuable to think about inflation as you calculate your portfolio spending plan, as you figure out how much to take out of your portfolio. If you have reason to believe that inflation will be high in, especially, the early years of your retirement, it makes sense to be a little bit more conservative in terms of your starting withdrawals. On the other hand, if you believe that inflation will be very, very low for whatever reason, you could potentially take a little bit more from that portfolio in terms of your starting withdrawal.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.