Imagine you have $1 million saved and you live in a fantasy world where there are no taxes. You need to take out $40,000 each year for expenses, a very reasonable 4 percent starting withdrawal rate. Inflation is 3 percent, but you can get 5 percent a year risk-free and tax-free on your investments. Your expenses increase at the 3 percent inflation rate.
Everything should be fine, right? Indeed, after 10 years your balance has grown to about $1.06 million and you feel comfortable. Then a funny thing happens. Your balance starts to decline, slowly at first and then faster. You are broke after 37 years.
What happened? Well, even though the rate of appreciation on your investments was higher than inflation, because the money you spent was not able to grow, the inflation rate on the expenses eventually overwhelmed the portfolio. Had inflation only been 2 percent, it would take 48 years to go broke. Only when inflation is down to about 1 percent does the portfolio continue to grow indefinitely in this scenario.
Inflation is the greatest destroyer of wealth in the history of the world, and it will eat away a lot of your money as well. Do not underestimate it when you are planning, especially regarding asset allocation decisions.
Due to the power of compounding, inflation has a much greater impact in long-time horizons than it does in short ones. If you have a long time horizon (more than 30 years), don’t assume that everything will be fine as long as your investment return is higher than your original withdrawal rate. If inflation rears its ugly head – even if your returns outpace it – you will still run into trouble.
More people go broke because they invest in “safe” bonds and annuities than do so because of stocks. This is because they don’t properly plan for inflation. In our portfolios, especially for those who are retired, we usually prefer to use inflation-protected securities for a significant portion of fixed-income allocations. A small allocation to “hard assets” or “alternatives” such as real estate or gold can also provide meaningful inflation hedges.