March 24, 2009
The average inflation rate since 1966 has been 4.60%. Most of that inflation, however, occurred in the 1970s and early 1980s. Since 1985, the average inflation rate has been 3.07%.
In each case, I determined the two “safe” withdrawal rates – one that eventually depletes the principal (analogous to Bengen and other studies) and one that retains the starting principal balance.
The results are as follows:
Assumed Inflation Rate |
Safe Withdrawal Rate (%) Depleting Principal |
Safe Withdrawal Rate (%) |
-2% (deflation) |
8.69 |
4.48 |
-1% (deflation) |
7.48 |
4.27 |
0% |
6.49 |
4.07 |
1% |
6.02 |
4.28 |
2% |
5.60 |
4.38 |
3% |
5.12 |
4.26 |
4% |
4.75 |
4.13 |
5% |
4.44 |
4.01 |
5.14% |
-- |
4.00 |
7.09% |
4.00 |
-- |
Historical inflation as of 1966 |
4.08 |
3.78 |
Historical inflation twice the 1966 rate |
3.28 |
3.25 |
The results have several key implications:
- A retiree can replicate Bengen’s “safe” withdrawal rate of 4% even with an inflation rate of 7.09%, more than twice the average inflation rate since 1985.
- Average inflation of 5% permits 4.01% withdrawal without depleting principal.
- Under the historical worst-case scenario – the inflationary environment of starting in 1966 – a 4.08% withdrawal rate remains possible.
- The portfolio performs exceptionally well in a deflationary environment (largely because the TIPS principal cannot go below par). Deflation is not unprecedented – the CPI declined 27% between 1929 and 1933.
- The true worst-case scenario is hyperinflation but, even assuming a 4% withdrawal rate and the last scenario above (twice the inflation rates starting in 1966), income from the portfolio exceeds withdrawals for the first nine years. Thus, the retiree has ample time to adjust allocations or reduce spending habits.
But these implications don’t even account for the true value of this portfolio – it is invulnerable to unpredictable market crashes, particularly those that might occur at the beginning of the retirement period.
Kitces’ research suggests that the safe withdrawal rate for a conventional equity-centric portfolio may be upwards of 5.5% if valuations slip a little further into the “undervalued” territory – and that’s a 5.5% minimum, with an average of over 7%. Thus, in lower valuation environments, retirees who choose an all-bond portfolio may trade a lot of potential upside for a little more certainty.
In the event of rapid and severe inflation, the retiree could shift assets from TIPS to municipal bonds, locking higher fixed rates.
Inflation has not been kind to equity-centric portfolios. The only modern experience with high inflation in the US was the 1970s, when inflation averaged 7.1%. During that decade, stocks returned 5.8% annually on a nominal basis (including reinvested dividends), but they returned just -1.4% on an inflation-adjusted basis.
Today’s retirees risk a similar environment in coming years, its likelihood amplified by each announcement of increased government deficits.
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