How Will Inflation Affect My FIRE Plans?

This is a guest post by fellow physician blogger known as Crispy Doc. He is a financially independent emergency physician, married with kids, and lives in coastal California. He blogs about financial literacy and burnout at www.crispydoc.com. He tweets, too: @crispydocblog.

A recent conversation with a financially brilliant friend led to the revelation that in addition to the usual suspects (health insurance before Medicare kicks in, Sequence Of Returns Risk), inflation remains a very real worry for those considering early retirement.

Inflation is the erosion of purchasing power over time. It's averaged 2-3% per year in recent history, although there have been notable years (1974 and 1980) where it exceeded 12%.

While the risk that inflation poses is far less than that posed by Sequence of Returns Risk (SORR). SORR is the risk that investment returns from your portfolio in the early years will be so low you run out of money before you have died. More about that later on…

Mattresses possess two major risks: conception and inflation

Conceiving an unplanned child on a mattress can undermine one's retirement plans as surely as inflation, but I'll conveniently exclude that topic from today's discussion to focus on the second mattress risk.

Keep a dollar in your wallet to spend later that evening, and your dollar does the job nicely. Keep that same dollar under your mattress for years and when you take it out, it buys less.

In a highly recommended series written by bloggers Big ERN and Actuary on FIRE, they describe how $1 million that remains un-invested (under the mattress) subjected to 2% annual inflation for 25 years will have the purchasing power of $600k at the end of that period. 

This is understandably scary for an early retiree counting on that stash but equally fearful of market volatility. 

Cash under your mattress will not suffice. You need to invest your dollar where it can keep pace with inflation or beat it. [Editor’s note: I like to call this – make your money work for you! Don’t let your green employees be lazy!]

Take home point: Cash is great in the short-term, lousy over the long run.

Cash is great in the short-term, lousy over the long run. @crispydocblog Click To Tweet

Sh*t's about to get real: a note on terminology

When considering portfolio returns, it's important to understand the difference between real and nominal returns.

The amount your portfolio earns above and beyond inflation is termed your real return.

In contrast, nominal returns do not subtract inflation.

This is a critically important difference. During the great recession of 2007, investors seeking safety purchased government treasury bonds with nominal returns below inflation.  These treasuries had negative real returns – investors actually lost money on these investments!

What investment tools can we deploy in our inflation-fighting toolkit?

Our investment toolkit includes equity (stocks) and fixed income (bonds, treasuries). 

Stocks represent an ownership stake in a company, with the potential to gain or lose value as the company grows or fails. 

Bonds are loans to a company repaid at a fixed interest rate. 

Treasuries are loans to the government.

Equity

Stocks are higher risk, higher reward. Bonds are lower risk, lower reward.

Stocks historically beat inflation in the long term, but at the risk of greater volatility in the short term. Throw a dollar in stocks for 30 years and you are extremely likely to come out ahead of inflation at the end of the time period. 

Throw a dollar in stocks for 30 months and it's anyone's guess if you'll win or lose. The loss could be half the value your dollar. 

Take home point: Only dollars that you can ignore for decades ought to go in stocks, but the expected growth should exceed inflation over the long haul.

Fixed Income

Fixed income investments like bonds offer a slow and steady return on investment that keeps pace with or just beats inflation. Money you'll need in the next several years belongs in fixed income. 

In fact, many investors create bond ladders – for example, they may invest in bonds that mature sequentially one year apart staggered over a decade. This keeps their investments liquid to ensure the money becomes available just in time to meet their spending needs, or alternately, can ensure they don't tie up all their money in a less remunerative bond if rates rise over that decade.

Fixed income investments are not, however, risk-free. The credit risk of a bond is that the issuer will go bankrupt before you are paid. 

Interest rate risk is the risk that when interest rates go up, the bond you own will decrease in value because investors can obtain a higher rate of return elsewhere.

Take home point: Bonds tend to beat inflation, with lower risk than stocks. They not only reduce the volatility of your investment portfolio, but are a safer place to park money you are counting on in the coming decade.

Treasuries

The United States has created a solution to credit risk by issuing Treasuries (government-issued bonds). Since the government can always print money, it is felt not to be at risk of bankruptcy (This works well in the U.S.; not so much in Zimbabwe and other unstable countries where no one assumes the government will survive the year). 

Take home point: Treasuries are considered to be completely free of credit risk but remain subject to interest rate risk.

Feeling TIPSy?

Uncle Sam has deep pockets, and you are his favorite niece. For this reason, the government has created a flavor of treasuries called Treasury Inflation-Protected Securities (TIPS), whose value increase is proportional to inflation. 

Returning to the example from Big ERN and Actuary on FIRE, if you were to invest $1 million in TIPS subjected to 2% annual inflation for 25 years, you will withdraw an amount that preserves the full purchasing power of your $1 million at the end of that period. 

But Uncle Sam is also a tough love uncle. If deflation occurs, the value of your investment drops proportionally.

Take home point: Invest in TIPS to protect against a jump in the inflation rate, so a dollar invested will retain full purchasing power at the time of withdrawal. The flip side is they can lose value in times of deflation.

How You Can Use These Tools To Protect Yourself At Retirement

In retirement, you are dealing with a new reality. Earned income from work has ceased, and you are living on a fixed income going forward that comes from your investment portfolio. Your goals are:

1. Guarantee we have enough to cover the initial years of retirement in a worst-case scenario such as poor sequence of returns.
2. Reduce the risk we take by increasing our bond allocation and reducing our stock allocation at the time of retirement.
3. Minimize the risk inflation poses to our portfolio.
4. Maintain a safe withdrawal rate low enough to last you until death.

One reasonable plan that incorporates these goals might be:

Maintain cash equivalents for the first 3 years of retirement. Year one should be cash in a money market account that gets transferred monthly into your checking account, years two and three can be invested in short-term CDs until you need to tap them for expenses.

Gradually shift asset allocation at retirement to increase fixed income since you can no longer risk the volatility of stocks. Let's say you are currently 70/30 stocks to bonds – a great recession striking the year after you retire could result in a loss of 35% of your portfolio, exactly when you lack the long time horizon to patiently wait for it to recover since you'll be living off of that portfolio. This is the dreaded SORR.

At retirement, you might go 50/50 (limiting your potential stock losses to 25%). Once past that critical first decade after retirement, you can consider upping your stock allocation gradually because you've made it beyond the most potentially devastating period when a sequence of returns risk could sink your retirement ship.

Another response to SORR is to remain flexible. If you can reduce your expenses when annual returns are low, you remain in a position of power.

Consider splitting your fixed-income investments evenly between bonds and TIPS, as TIPS will help you hedge against inflation risk. (The Vanguard Target Retirement Funds tend to split fixed income roughly 1/3 TIPS, 2/3 bonds at the time of retirement, for comparison.)

Finally, despite the FIRE community's general adoption of the 4% safe withdrawal rate, a more conservative 3-3.5% withdrawal rate will inevitably provide a buffer of safety that lets you sleep more soundly at night. This is doubly important for the early retiree, since the 4% safe withdrawal rate in the original Trinity Study was designed to survive a 30 year time horizon and many seeking FIRE will need their portfolios to last decades longer.

As Dr. William Bernstein has so eloquently put it, “The purpose of investing is not to simply optimize returns and make yourself rich. The purpose is not to die poor.”

With a better understanding of the investing tools in your tool belt, you will be less likely to need to tighten that belt in retirement!