Retirement is a phase of life that many look forward to, a period for relaxation, exploration, and fulfillment after decades of hard work.

However, achieving a comfortable retirement requires more than just accumulating a substantial nest egg; it demands strategic planning and foresight, particularly in safeguarding against economic factors that can erode the value of your savings.

Among these, inflation stands out as a silent but relentless force that can significantly lower the purchasing power of your portfolio, thereby impacting your retirement spending and quality of life.

For retirees and those nearing retirement, understanding and preparing for inflation is crucial, yet there's a more nuanced threat that often goes overlooked: the "sequence of inflation risk."

This concept highlights the timing of inflation spikes and how their occurrence early in retirement can have a disproportionately negative impact on the longevity of your savings.

Inflation attacks you from two fronts:

• The steady erosion of purchasing power

• The timing of when such inflation occurs

Unlike the steady erosion caused by inflation over time, the sequence of inflation risk poses a more hidden and less understood threat to your financial security.

In today’s note, we’ll examine the loss of purchasing power due to inflation. I’ll call this Part I.

On Wednesday we’ll review the sequence of inflation risk concept that is often much less understood. This will be Part II.

The Steady Erosion of Purchasing Power - Part I

The theoretical understanding of inflation and its risks is one thing, but seeing its impact play out in the lives of real people brings home the importance of effective retirement planning.

Everybody understands what happens when inflation spikes up. The last three years have been eye-opening, especially after a long period of low inflation.

Before COVID-19 hit nobody would talk about inflation. Since the pandemic, however, inflation has been a widely discussed topic from the halls of the Federal Reserve to the dinner table.

Let’s take a look at the last four years. As the pandemic took hold in March 2020 consumer prices initially kept steady and the big fear amongst policymakers was the possibility of deflation.

However, as the global economy ground to a halt supply chain imbalances became the norm and prices started rising aggressively. Coupled with highly stimulative fiscal and monetary policy inflation went from 1.3% in 2020 to 7.2% in 2021. The last time the US inflation rate had been that high was in 1981.

Not only did we experience a nasty inflation surprise in 2022 but the inflation rate has remained stubbornly high since then. In 2023 the US registered a 6.4% increase, and in 2023 inflation clocked in at 3.1%.

The purchasing power of US consumers has been hammered in the last few years.

Since the end of 2020, consumers have lost 16% of their purchasing power due to inflation in the US.

High Inflation Also Affects Asset Class Returns (in a bad way)

Inflation in the US has averaged 3.3% over the 1914-2023 period.

Many advisors use a standard assumption of between 3 and 4%. Such an assumption is entirely reasonable as a measure of central tendency, but such an approach fails to account for the variability of inflation from year to year.

Over the 1914 to 2023 period, inflation has ranged between -11% to 20% per annum with a standard deviation or measure of variability of 4.7%.

Based on the history of inflation in the US we classify each year into three buckets:

• Low Inflation: Less than 1.30% (occurring 25% of the time)

• Normal Inflation: Between 1.31% and 4.35% (occurring 50% of the time)

• High Inflation: Greater than 4.36% (occurring 25% of the time)

 Asset Class Returns by Inflation Regime

Asset class returns can be significantly affected by the prevailing inflationary environment. Over the 1928 to 2023 period, real returns (after inflation) have averaged 8.4% for stocks and 1.9% for 10-year Government Bonds. There are, however, some big differences depending on the inflationary environment.

Inflation can eat into people’s standard of living but it can also wreak havoc with asset class returns.

Another problem is that Inflation can be persistent as well as variable. Periods of high inflation tend to be clustered together in time and the same applies to periods of low volatility. This has been one of the reasons why the US Federal Reserve along with other monetary policy decision-makers has had such a hard time quickly driving the inflation rate closer to their intended target of 2%.

Just as with stock and bond returns, inflation rates are not static and can vary considerably from year to year. Financial planning exercises should consider the variability of inflation rates rather than assume a flat, unchanging rate.

In addition, asset class returns can be significantly affected by the inflationary environment.

When inflationary forces are at their strongest they are eating into your lifestyle dreams through both higher consumer prices and lower expected portfolio returns.

Surviving High Inflation

The impact of inflation on retirees emphasizes the need for flexible retirement planning. Strategies that might have worked at the onset of retirement may need to be adjusted as economic conditions change. For retirees like Alex and Jordan, adapting might mean:

Reducing Withdrawal Rates: Temporarily lowering the amount withdrawn from the retirement portfolio during periods of high inflation can help preserve capital.

Investing in Inflation-Protected Securities: Assets like Treasury Inflation-Protected Securities (TIPS) can provide a buffer against inflation. The principal value of TIPS increases with inflation and decreases with deflation, which is reflected in the interest payments that investors receive. This makes TIPS a cornerstone for any inflation-conscious retirement strategy.

Commodities: Investing in commodities like gold, oil, or agricultural products can offer protection against inflation. These tangible assets tend to rise in value when inflation increases, providing a natural hedge against the eroding value of currency.

Real Estate: Real estate investments can also serve as an effective inflation hedge. Rental income from property investments can increase with inflation, which helps maintain the purchasing power of those earnings. Additionally, the value of the property itself may appreciate over time, further enhancing its role in a diversified retirement portfolio.

Stocks with Pricing Power: Equities, particularly those of companies with strong pricing power, can also be an effective hedge against inflation. Companies that can easily pass increased costs onto consumers without losing demand are likely to maintain or even increase their profitability during inflationary periods.

Diversifying Income Sources: Having multiple sources of income, such as rental income, dividends, and part-time work, can help retirees manage through inflationary periods without heavily depleting their investment portfolios.

Building a retirement portfolio that can withstand the impact of inflation requires careful planning and ongoing management.

High Inflation hits you on two fronts - rising consumer prices and lower expected rates of return on your portfolio.

By incorporating real assets, TIPS, and equities with strong pricing power, retirees can create a diversified portfolio that not only hedges against inflation but also supports a sustainable withdrawal strategy.

It's about creating a financial foundation that allows for adaptation and growth, regardless of economic conditions.

An effective retirement plan isn't just about saving enough; it's about ensuring those savings continue to work for you, maintaining their value and generating income in the face of inflation.

The Big Picture:

• Equities keep outperforming bonds. The dominance of US large-cap equities has been a key driver of the outperformance over the last decade.

• The big losers last week were Real Estate investors in particular those with heavy exposure to refinancing risk. REITS are currently offering attractive yields. For example, the popular Vanguard Real Estate Index Fund ETF (VNQ) is currently yielding over 4%.

• Cash is again outperforming bonds this year. Until there is more clarity as to the direction of Fed policy this situation is likely to persist.

• The investment environment remains risk-on. Aggressive asset allocation strategies continue their outperformance.

Economy:

• There do not seem to be any major short-term concerns for the US economy except for how to lower inflation to a level where the Fed will lower rates.

• Growth is good, the employment picture seems robust and consumer sentiment remains upbeat.

• A “Goldilocks” economy as described above always scares me. People get too complacent and expect everything to continue this way forever. This is what creates nasty surprises. Where could I see some nasty surprises?

• The first area would be commercial real estate where over a trillion of debt needs to be re-financed at the same time that office occupancy rates are plunging.

• The second is housing in the form of affordability unless mortgage rates come down.

• The third is AI and automation in general displacing a large swath of lower-end jobs.

• Finally, the US is in an election year and this year’s contest will likely surpass all others in terms of vitriol and divisiveness.

Equities:

• US Large Cap equities dominated last week with the S&P 500 up 2.3% while the Small-Cap Index, the Russell 2000, returned 1.5%. Year-to-date the S&P 500 is up 10.1% with the Russell 2000 is up 2.5%. We’ve been expecting a tightening in return differences between large and small caps but if anything the gap is widening further.

• Growth outperformed value once again. The gap remains wide with the S&P 500 Growth Index up 13.6% YTD while the Value index is up 7%. YTD.

• On the international front, the Japanese equity market continues its rebound. Last week the MSCI Japan Index was up 4.2%, the best among major global markets. Year-to-date Japanese equities are up 12% after returning over 20% in 2023. All of these returns are in US dollar units. Japan is YTD the best-performing major equity market even after allowing for a depreciating Yen.

Bonds:

• The Federal Reserve stood pat last week with no rate cuts on the near horizon. The Governors did, however, maintain their belief that in 2024 there will be 3 interest rate cuts. We just don’t know when.

• Long-maturity Treasury bonds gained last week as long-dated interest rates came down marginally while short rates stood firm. This is in contrast to the prior week.

• Year to date the performance of short-maturity bonds has trounced the return of long-maturity bond strategies. The iShares 20+ Year Treasury Bond ETF (TLT) is down 4.3% for the year.

Signal Versus Noise

What’s Coming on Premium Wednesday😀 

• Asset Allocation Performance - Portfolio Implications

• The “sequence of inflation risk” - Part II

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