Inflation vs. the Bear: Which is worse for retired investors?

At first blush, it seems as though a bear market would be the biggest threat to your clients' retirement income security.

At first blush, it seems as though a bear market would be the biggest threat to your clients’ retirement income security. Nobody likes to see the value of their portfolio decline by 50% or more while they’re trying to live off their money.
But if you study historical data on retirement distributions, the periods that caused the most difficulty were periods of high inflation. The reason is that while a bear market is difficult, clients can control their exposure to falling equity prices by adopting a more conservative allocation. Of course, if you fail to build some safety into your portfolios, a bear market alone can doom your clients. But assuming you’re modestly conservative, the bear market can be managed.
There are lots strategies you can use to generate distributions during bear markets. Here are a couple of approaches that make bear markets survivable, although not necessarily comfortable: First, clients can take distributions of their bond interest and stock dividends to create a base income stream. Second, they can tap into cash reserve accounts to avoid liquidating assets at fire sale prices. And third, if there is low or no inflation, they can cut back on their spending without significantly impacting their lifestyle during the bear market cycle.
Inflation, however, poses a different challenge. Because it’s ubiquitous, investors really can’t escape its impact. As prices rise, their spending generally has to rise. Broad based and sustained inflation above 5% would put your retired clients in a pickle 15 to 20 years down the line.
Consider that if inflation runs at 6% for 20 years, your clients’ distributions must grow by 320% just to keep up with the rising cost of living. Thus, if they started their retirements assuming they could withdraw a 5% inflation-adjusted distribution, their distribution rate at the end of that 20 year period would grow to 16% of their original portfolio value. That will be a tough nut to cover, even in good markets.
The last big inflationary cycle ran from 1966 to 1985. During that period, inflation clocked in at 6.36% per year. Assuming a $1,000,000 portfolio in 1966, an initial $50,000 distribution (5%) would need to grow to $171,000 by 1985 to maintain the same standard of living.
But if inflation only ran at 2% a year, the distribution needs would grow by only about 50% over those 20 years. That means the 5% initial distribution would grow to about 7.5% of the original account value. That’s a manageable increase, and only requires some modest returns in the financial markets. Even if the client couldn’t keep up with the inflation adjustments dollar-for-dollar, because the inflation is mild, it’s likely the client could cut spending and not be that much worse off.
It seems ironic to be thinking about inflation when it’s tough to squeak out 3% to 4% interest for your clients in the bond market and inflation is running at about 1% year-over-year. But markets can change quickly; and if inflation spikes, you’ll need some ability to adjust your clients’ portfolios.
For your fixed income holdings, make sure you have the opportunity to adjust to higher rates if inflation picks up. A laddered approach using individual bonds or targeted bond ETFs (or a little of both) would make good sense. As rates rise and your bonds mature, you can reinvest the capital at higher yields.
You should be cautious with actively managed bond funds because it’s possible the bond manager could make the wrong call on interest rates and lock in real losses. Since many bond funds are managed for total return, as opposed to just collecting the coupon, it’s likely some will make mistakes when it comes to predicting interest rate moves and lose big money for their investors.
Consider a passive approach to TIPs. While they don’t produce much income today, they will provide a direct offset to CPI increases over the years. You may want to ladder them as well, as TIPs have both an interest rate component and an inflation component. If interest rates rise, you’ll still want the ability to reinvest principal every few years to capture the higher rates.
Be careful with fixed annuity payouts. Interest rates are at all time lows, and those fixed or immediate annuity payments could be ravaged by inflation. If you want to use annuities, consider staggering the investment cycle so you don’t get caught locking in one low rate for the investor’s entire retirement.
Consider stocks as a longer term inflation hedge. While the returns are unlikely to correlate precisely with a jump in inflation, as prices rise, companies adjust their prices and the higher dollars flow through as bigger total earnings and dividend payments. Over time, those increases can help your clients maintain their purchasing power.
Don’t forget about Social Security. As an inflation-adjusted income stream, the longer you can convince clients to wait before they tap their Social Security benefit, the better inflation hedge they will have because the CPI adjustments are applied to a higher dollar amount.
Charles Farrell is a principal with Northstar Investment Advisors, LLC in Denver. He is the author of Your Money Ratios: 8 Simple Tools for Financial Security, and the developer of the Farrell-Northstar Retirement Income Index.
If you have other ideas or questions about how to combat the possibility of inflation for retirement income investors, please feel free to submit your comments or discussion items below. To ask other questions concerning retirement, go to our retirement planning forum and click “Start new discussion.”