In the previous note, we examined how inflation acts as a long-term tax on your purchasing power. In the case of the US investor, the last three years have been brutal in this regard. A $1 in 2020 only buys $0.84 of goods and services at the end of 2023.

We also examined how inflation affects stock, bond, and cash returns. Specifically, how during periods of high inflation asset class returns tend to, on average, experience negative real returns.

For example, fixed-income investments often representing a significant portion of the typical retiree’s portfolio have yet to break in real terms over the last three years.

Inflation does not only increase your cost of living but it also hurts your portfolio returns. In addition, the timing of when inflation happens called the Sequence of Inflation Risk increases the uncertainty of your financial life.

In today’s note, Part II, we’ll examine the Sequence of Inflation Risk and how the timing of inflation can seriously affect the value of your retirement portfolio.

What is the Sequence of Inflation Risk?

The sequence of inflation risk refers to the risk that an unfavorable order of inflation rates will occur early in retirement, potentially depleting retirement savings more rapidly than expected.

This is particularly dangerous because withdrawals are often planned based on the initial value of the portfolio, not accounting for the dynamic nature of inflation.

If a retiree faces high inflation rates early on, they may need to withdraw a larger portion of their portfolio to maintain their standard of living.

Over time, this increased withdrawal rate can significantly reduce the lifespan of their savings, especially if the portfolio cannot generate enough returns to offset the withdrawals.

The Real-World Impact of Inflation on Retirees

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. The sequence of inflation risk is not just a financial concept; it's a reality that can alter the course of one's golden years.

The Case of 4 Retirees:

Let's consider the case of Royce, Mary, Elsa, and Jamal.

• Royce retired at the end of 1993 after a long career in computer sales. The economy was in full swing but it was time.

• Mary retired at the end of 2003 having barely survived the economic slowdown of the early 2000s.

• Elsa finally retired at the end of 2013, 5 years after her initial plan was derailed by the Financial Crisis.

• Jamal was forced to retire at the end of 2020 after his long-time employer went under due to the sharp contraction in economic activity from the pandemic

Using the actual calendar year inflation experienced in the US let’s look at how their purchasing power has changed over time. They each start with $100 in purchasing power at the beginning of their retirement journey.

High-Level Observations:

• Royce who has been retired the longest has seen his purchasing power erode by almost 54% ($100 in 1993 now buys only $46 of goods and services).

• Mary who retired in 2003 has seen her purchasing power erode by 41%. 20 years have gone in the blink of an eye but prices for everything sure have gone up.

• Elsa has found her groove in retirement but the last few years have dented her budget given the sharp rise in prices since Covid-19. Her purchasing power has eroded 25% in the last ten years.

• Finally, Jamal has barely settled into life in retirement, and he already has had to revise his living expenses to more realistic levels given the spike in inflation over the last few years. Since he retired three years ago he’s seen his purchasing power erode by 16%.

Inflation has eroded everybody’s purchasing power but Elsa who retired in 2013 seems to have suffered the least. Of course, she hasn’t been retired as long as Royce and Mary, and inflation may stay high over her remaining years in retirement. For now, Elsa seems the winner.

The clear loser three years into retirement is Jamal. Unfortunately for him and unlike the others Jamal retired when inflation was about to spike up. By the end of his first year in retirement, his purchasing power has already eroded 8%. Yikes! And there was more to come in the second and third years.

These examples illustrate how high inflation early in retirement can have a more substantial impact on a retiree's portfolio and spending power compared to higher inflation later in retirement.

This is because the portfolio value is typically at its highest point at the beginning of retirement, and any losses due to inflation are amplified when withdrawals are taken from a smaller remaining balance in subsequent years.

It’s not just that inflation erodes one’s nest egg, but also the timing of when most of the erosion occurs. If it happens early in retirement, as in the case of Jamal you’ll be forced into revising your expectations and cost of living assumptions much earlier than in the case where inflation is low and steady.

The fact that high and low inflation years tend to cancel out over time is little consolation to those unlucky individuals retiring at the same time as a spike in inflation. Their well-crafted plans will need to be revised almost immediately to prevent their funds from being severely depleted.

The assumption that most advisors use in their planning exercises is that inflation is steady. A 3 to 4% inflation rate is typically used for US-based individuals.

Using a fixed rate assumption is however risky as the timing as to when inflation hits is key. In my opinion, investors should look at the rate of inflation in the same way as they look at asset-class returns - both are highly variable from year to year and their path or sequence is important. The same Monte Carlo simulations used for asset class returns should be applied to inflation rates.

Strategies to Manage the Sequence of Inflation Risk

Periods of high inflation are not easy to navigate. Not only are you seeing the price of goods and services skyrocket in front of your eyes but frequently the economy and capital markets are also stressed at the same time.

Remaining calm and committed to your financial plan is a first step, but most likely you’ll have to re-examine your spending and investing assumptions.

Based on your read of how sticky or permanent the change in purchasing power is likely to be here are some additional strategies you may consider.

 Dynamic Withdrawal Rates: The Bengen Rule

Consider the case of the "4% rule," developed by financial advisor William Bengen in 1994. Bengen's analysis of historical market returns led him to suggest that retirees could withdraw 4% of their portfolio in the first year of retirement, adjusting the amount for inflation in subsequent years, without depleting their savings over 30 years.

However, given the unpredictable nature of inflation, Bengen himself advocates for flexibility in withdrawal rates.

For instance, during the 2008 financial crisis, retirees who adjusted their withdrawals downwards preserved more of their portfolio for future recovery, demonstrating the importance of adaptability in the face of economic volatility.

Diversification Beyond Traditional Stocks and Bonds: Real Assets

Real Assets such as real estate and commodities offer a compelling example of inflation-resilient diversification.

Historically, real assets have provided returns that outpace inflation. Real estate operators can for example increase rents while also enjoying higher property values. For example, during the inflationary period of the late 1970s and early 1980s, REITs demonstrated strong performance relative to the broader stock market, highlighting their role as a hedge against inflation.

Similarly, commodities usually spike up during inflationary periods. Having a small allocation to commodities in a diversified portfolio won’t fully hedge all your inflation risk away but chances are that you’ll get an incremental return.

Embracing Inflation-Protected Securities: Treasury Inflation-Protected Securities (TIPS)

Treasury Inflation-Protected Securities (TIPS) directly counter inflation's impact by adjusting the principal value of the bond with changes in the Consumer Price Index (CPI).

A practical example of their effectiveness can be seen in the early 2000s when inflation concerns grew in the aftermath of the dot-com bubble. Investors who included TIPS in their portfolios benefitted from the automatic adjustments that preserved the real value of their investment, providing a cushion against the eroding effects of inflation.

TIPS should be a core holding of retirees especially those not lucky enough to have a defined benefit pension plan with inflation escalation clauses. Unfortunately, most of today’s retirees do not have such protection.

Staying Flexible and Informed: The 2020 COVID-19 Pandemic Response

The COVID-19 pandemic and the subsequent economic recovery process underscore the importance of flexibility and informed decision-making.

Investors who stayed informed about the Federal Reserve's policies and market trends, and who were willing to adjust their investment strategies - such as increasing their exposure to asset classes such as equities and commodities that typically keep up with inflationary trends - navigated the pandemic-induced loss of purchasing power more successfully.

This adaptability was crucial in managing the inflationary pressures that emerged during the recovery phase.

Asset Allocation Performance Review

High-Level Observations:

• Conservative portfolios with a heavier allocation to bonds are still recovering from the 2022 capital market collapse but the trend is up. Over the last three years, the GF Low-Risk strategy is only up 2% on an annualized basis (before fees and transaction costs). Going back 5 years the annualized performance improves to 4.9%. The Morningstar Income strategy has performed even worse at an annualized return of 0.6% over the last five years.

• Equity-heavy allocations have outperformed more conservative allocations thanks largely to the performance of US large-cap equities. The GF Higher-Risk strategy is up 4.2% on an annualized pre-cost basis over the last three years. over the last 5 years, the strategy is up a respectable 7.9%.

• In the last few weeks, we have seen signs that US Large Cap Equity will not always dominate the other asset classes. For example, over the last 5 trading days we’ve seen the other equity asset classes - US Small, Emerging, and International - outperform the S&P 500.

• Bonds are showing signs of stability but are still highly dependent on monetary policy in the US and offshore. Over the last 5 days, US Bonds were up 0.5%.

• Real Estate continues to be a drag on performance. Reits were down 1.5% over the last 5 days. I expect Reits to recover but for now, sentiment is clearly against this asset class. The commercial real estate sector as well as retail-focused Reits are also challenged by deteriorating fundamentals.

Weekly Performance Attribution

Source: iShares, as of 3/26/2024

A Bit of Humor Never Hurts

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