Don’t overlook inflation

Retirement income portfolio success depends highly on how financial advisers adjust distributions to address inflation, and tweaking the annual inflation adjustments can significantly raise the likelihood of portfolio survival.

Advisers are familiar with retirement income distribution statistics. A 4% inflation-adjusted distribution rate has had more than a 95% probability of success on a historical basis.

If you increase the distribution to 5%, the success rate falls to about 70%. And if you move the distribution to 6%, the success rate is about 50%.

Why is it that small adjustments in the distribution rate have such vastly different outcomes? Basically, it all has to do with inflation.

In a high-inflation environment, a larger initial distribution rate compounds the pressure on the portfolio 10 to 20 years down the road. Dropping the initial distribution rate by a small amount can make a big difference, as the inflation adjustment is compounding off a lower number.

One cycle that helps illustrate this point is 1962 to 1991. During that period, the Standard & Poor’s 500 stock index returned 10.3%, which is about its long-term average.

Given that return, a balanced retirement account should support a 5% inflation-adjusted distribution.

When you run the numbers, however, you discover that at a 5% inflation-adjusted distribution, the investor would have depleted his or her funds in about 1986. The portfolio fails because of a combination of the 1973-74 bear market and the accelerating inflation of the 1970s.

As distributions grew to keep up with inflation, they consumed an even larger portion of the account balance each year. For instance, on a $1 million account, the distribution grew from $50,000 in 1961 to almost $182,000 by 1986, or 18% of the original account value.

If you drop the distribution rate to 4%, however, the portfolio does just fine. At the end of the 30 years, the $1 million initial portfolio is worth about $1.25 million, all the while making annual inflation-adjusted distributions.

At 4%, the inflation-adjusted distributions were low enough that they didn’t substantially deplete the account before the bull market returns of the 1980s could help rebuild the portfolio.

For instance, at 4%, the 1986 distribution was $145,000, compared with $182,000 under the 5% scenario. That gap in the annual distributions is enough to allow the portfolio to survive and recover.

Because inflation is the main culprit, it is also interesting to investigate how the portfolio would perform using the higher 5% initial distribution rate, but with smaller annual inflation adjustments.

If we reduce the 1962-91 inflation adjustment by half using the 5% distribution rate, the portfolio survives the entire 30 years and ends with about $1.8 million in the account. If we don’t adjust at all for inflation and distribute 5% of the original value for all 30 years between 1962 and 1991, the ending value skyrockets to almost $4.3 million.

Although investors often become most concerned about the dramatic effects of a bear market, the real threat is the long-term pressure created by inflation. Bear markets alone generally aren’t the problem; it is a bear market combined with an accelerating inflation rate.

Advisers, however, must be careful about assigning too much credence to the historical research.

The research is helpful in identifying risk factors, but it isn’t predictive. Each cycle and crisis unfolds in a different manner.

From a risk management standpoint, the historical research is helpful in identifying when you may need to modify your strategy. If you know that the most difficult periods have seen some combination of a bear market and high inflation, then you should modify your distribution strategy when presented with the initial signs of such a pattern.

Small reductions to the inflation adjustment can help preserve enough capital such that when the markets do recover, the portfolio value is restored to a healthier level. Because there is no optimal distribution strategy that will work in every cycle, your sound judgment be-comes the most important factor in managing retirement income distributions.

Charles J. Farrell, JD, LLM, is an investment adviser with Northstar Investment Advisors LLC in Denver.