Sixty-five year olds have a remaining life expectancy of about 20 years. And that means 50% will live even longer. So you should plan for your retirement income to last for at least 25 years. By all measures, inflation will take a big bite of a dollar's purchasing power over that time. Below, I review inflation's effect and the amount of portfolio growth you'll need to maintain your purchasing power in your withdrawal income.
The year to year fluctuation of inflation's value can be dramatic. In the 70s and early 80s inflation some years reached over 10%. But when inflation is averaged over 30 years, the average annual rate has remained in the lower single digits.
Each consecutive 30 year period beginning with 1946-75 (2nd period would be 1947-1976) and ending with the 1976-2005 period, gives average annual inflation rates (over that 30 year period) that range from 3.43% (1949-1978) to the highest at 5.44% (1966-1995).
These rates may not seem high, but over 30 years, a 3.43% annual inflation requires you to spend $ 1.00 at the end of that period for what 34 cents bought at the beginning. A 5.44% rate requires a $ 1.00 to buy what 19 cents bought at the beginning. That's serious purchasing power erosion.
You can see that you'll need to take into account inflation's effect on any retirement income you expect to use. Perhaps a reasonable projection for the average inflation for your 30 years of retirement may be about 4.5%. If so, you'll need $ 4 at the end of those 30 years to buy what just $ 1.00 bought at the beginning.
Inflation's Effect on Your Retirement Income Pillars:
Typically your retirement income is made up of your Social Security income, your pension income and whatever income you withdraw from your savings.
Fortunately, Social Security income is indexed for inflation; but, unfortunately, most pensions are not. So the purchasing power of your pension income will slowly decrease. Both these income sources will run for you lifetime.
Your savings can be a source of retirement income. But if you take too much each year, you can ever deplete your savings – leaving you with nothing. To be sure it lasts 30 years, it's safe to withdraw only its alert – not its principal (ie the amount you started your retirement with).
But how much can you annually withdraw that meets a constant purchasing power? Realize that under a 4% annual inflation, you'll need $ 1.00 after 21 years into your retirement to pay for what 40 cent bought at the beginning of your retirement. So you can see you need to invest your money to offset the dollar's erosion.
Protecting your inflation-adjusted principal while withdrawing yearly income If your savings grow only at the inflation rate, then its total purchasing power just remains the same. Call that inflation growth principal – your inflation-adjusted principal. This 'increasing dollar' amount should not be withdrawn -since it would mean that you're eating into your principal.
You should only withdraw that portion of your principal that grows faster than inflation – ie the excess annual growth over and above the inflation-adjusted principal. So, you must invest your savings so that it has an annual growth rate that is greater than the inflation rate if you expect to withdraw income without diminishing the 'value' of your savings.
If you're anticipating a 4.5% average annual inflation rate, then your portfolio must grow at 8.5% in order to withdrawal 4% (= 8.5% – 4.5%) annually for income. Withdrawing this much leaves your portfolio at its inflation-adjusted principal value.
If you can maintain this growth rate year after year, your 4% withdrawal amount will automatically pull out an amount that increases with the inflation rate – since your inflation-adjusted principal is growing too. That keeps your withdrawal income indexed to inflation – and preserves its purchasing power.
Historical Growth Rates for Investments Historically (from 1926 – 2006), large-company common stocks have an average rate of return of 10.4%. Smaller company returns averaged 12.4%. But both these equity-based investments show a lot of volatility. Unfortunately, with higher returns coming more volatility – ie price and return fluctuations.
If you expect to get the high returns for stocks, you must commit to longer holding times to weather those annual fluctuations that will take place. Long term Government Bonds (5.4%) and Treasury Bills (3.7%) show much less volatility but then their returns are much less too.
To maintain growth with some protection against downward fluctuations, you must diversify your portfolio between different asset classes – one portion to grow over a long investment horizon and another portion to deliver returns you can more assuredly count on in the short run.
At least 50% of your savings should be in growth equities to fight inflation's effects. Just what growth rate you can get – and inflation rate you use – will determine what withdrawal rate will get you through your retirement years and maintain its purchasing power.