Inflation risk can compound all other risks if it’s not confronted in your planning. Learn what it is and how you can plan to control it within your portfolio.
You Know About “Sequence of Returns Risk,” but What about “Sequence of Inflation Risk”?
Much has been written on the very real “sequence of returns” risk facing retirees relying upon their own capital to generate a lifetime income. Retirees who have the misfortune of beginning their income withdrawals during a period of negative market returns have a steep uphill climb just to keep from depleting their assets too soon. While no one can predict the sequence of returns on their portfolio, there are ways to mitigate the risk through strategic planning and timing withdrawals.
But what about the lesser known “sequence of inflation risk?”
Could starting income withdrawals during a period of high inflation have as big of an impact as starting it during a down market? And are there measures that can be taken to mitigate the risk?
What Exactly is Sequence of Inflation Risk?
As with sequence of returns risk, sequence of inflation risk has to do with the order in which bouts of high inflation occur over a period of time. A retirement income portfolio that experiences negative returns in the early stages of withdrawals risks a faster depletion rate to make up the income shortfall in any given year. Sequence of inflation risk could have the same outcome, faster depletion of assets due to the need to draw down more income to cover increasing costs. For new retirees caught at the wrong end of a sequence of returns, starting withdrawals during rising inflation would compound a severe problem.
How does Sequence of Inflation Risk Impact my Retirement Portfolio?
Let’s take an example of a new retiree with $50,000 in expenses. He draws $30,000 from Social Security with an inflation-adjusted COLA. So, he must be able to draw $20,000 from his investment portfolio to make up the shortfall. Assuming he has $500,000 invested, he will need to draw down 4 percent each year.
Using an extreme example, let’s say inflation shoots up to 20 percent as he begins to draw down. His expenses are now $60,000. He’ll get an inflation adjustment on his Social Security to bring it up to $24,000. His income shortfall is now $26,000, which means he will have to increase his withdrawal rate to about 6.5 percent.
Here’s the real problem with beginning retirement during a rising inflationary period. Generally, once inflation hits, especially if it continues to rise, there’s no going back. In other words, unless we experience an extended period of deflation, once prices rise, they rarely fall back to their pre-inflationary levels. So, inflation at the beginning of retirement will continue to plague retirees throughout their lifetime.
This raises the question of whether there is an actual “sequence” of inflation risk or, rather, whether the real threat is simply the existence of inflation. Inflation at any time is a challenge for retirees. Of course, the later it occurs in retirement, the better. If an inflation spike didn’t occur until the last few years of retirement, it would have little, if any, negative impact.
The other fundamental difference between sequence of returns risk and inflation risk is that, at retirement, a person has minimal control over the sequence of returns, except to adjust his portfolio and take on more risk, which isn’t advisable. Inflation is almost a certainty. We can expect it and plan for it by adding inflation hedges to our portfolio. We can also adjust for it by reducing expenses, taking fewer vacations, getting part-time work, or downsizing in all areas (house, car, etc.). While it is perhaps a more controllable problem, it is still a problem, nevertheless. Whatever you want to call it, inflation risk can compound all other risks if it’s not confronted in your planning.
Read other situation analysis articles