Continuing our examination of risk in retirement, in this post we’re looking at inflation risk. Inflation is something we don’t really think about while we’re working. That’s because for the most part, earnings rise in excess of inflation, and so we get a little bit better off each year.
If your income generally rises more than things increase in price, you’re going to be able to buy a bit more next year. Now I know that’s a generalisation, so don’t shout if that’s not your personal experience – I do understand.
But inflation is a much bigger deal in retirement because generally speaking our income, other than the state pension or any DB schemes we have, might not be set to rise with inflation. Also, a greater proportion of our expenditure tends to be made up of things which rise in cost at a greater rate than the general rate of inflation, things like food, fuel and leisure spending.
If we’re drawing an ‘income’ from our portfolio, then that too will need to rise each year. In turn that means we’ll need to invest somewhat aggressively to make sure we’re getting super-inflationary growth, ideally.
Or at least we need to accept that we’ll erode our capital and we just need to try to make sure that it doesn’t erode too quickly and run out before we shuffle off. If inflation is a bigger factor in retirement, what can we do about it?
Well, the investment approach is a big factor. We need not to be afraid of investing somewhat aggressively, especially towards the top of the Cashflow Ladder. When we come to rebalance our portfolio, we need to be careful to try and do so thoughtfully, rather than just a blanket rebalance.
Usually, the default option would be to top up cash reserves from the bond or fixed interest portion of our portfolio, leaving the equities intact, but that still requires us to have a mind to the overall balance – we wouldn’t want to end up too equity heavy, because that would change the risk profile of the whole thing. Essentially, it’s a question of reviewing things intentionally.
While we can’t do anything about inflation itself, as with all these things, half the battle is about being prepared for them by thinking about the impact ahead of time. When I’m planning for clients using the cashflow modelling tools, we always factor in all costs rising by inflation.
We also use conservative estimates for variables like investment growth, to try and build in conservatism when planning. It may be that you’ve never really thought about inflation like that.
I do wonder if some of the proponents of FIRE who are so enamoured of the 4% rule have really factored inflation in to that. It’s all very well having 25x your annual expenditure in liquid assets, but if your annual expenditure doubles every 15 or 20 years due to inflation, then that needs to be factored in. Countering that is the evidence that on average, spending reduces over time in retirement.
So, planning helps to mitigate the impact of inflation. There would be nothing worse than planning for a long retirement, but vastly underestimating your expenditure over that time.
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