Ask the average person who is planning to retire and will have to depend on an investment portfolio for part of his income and he will tell you one of his biggest concerns: losing his principal. Then he’ll often add that perhaps it is time to get more conservative with his investments in order to avoid volatility that could destroy his retirement nest egg. The first concern is legitimate: it is very hard to rebuild a damaged investment portfolio once someone retires and no longer earns income that can be added to the portfolio. The second concern, however, misses the biggest threat to retirement success: It’s not short-term swings in market prices that damage a retirement portfolio but inflation that is the destroyer of long-term wealth.
Year in and year out inflation eats away at the value of your capital. And there is no “make-up” period: disinflation, that is, periods when inflation falls, are almost as rare as sightings of Bigfoot. The last calendar year consumer prices fell in this country was 1954. Before that one had to go back to the low point of the Great Depression to find prices falling.
Investment market swings, by contrast, can be brutal, but are also relatively short, usually lasting just months or at worst two or three years. And they are followed by market recoveries that help to rebuild wealth in a portfolio.
As we live longer on average, inflation becomes a bigger concern in retirement. It is becoming common for workers to live 20, 25, or even 30 or more years after they receive their gold watches. That means a retiree must plan on a having a growing income stream over retirement. A retiree can’t begin with a fixed income and expect it to carry her through the years.
For example, suppose you retire today on a $50,000 fixed pension. What if you experience the same rates of inflation that occurred over the last 20 years? The latest figures, for October 1986 through October 2006, show that consumer prices increased by 83%.
That means your pension would have to grow to $91,500 in 20 years just so that you could maintain your standard of living. And that’s for an average annual inflation rate of just 3%. There have been 20-year periods in the past when inflation has been higher than that.
The first lesson, then, is do not retire if you are going to stretch your income to its limits. If you need $50,000 a year and the income from your portfolio, your pension, and Social Security will provide just that amount, you may be heading for trouble in the future. While Social Security is currently indexed for inflation, it is likely that your pension is not.
In that case, you can’t take an unreasonable income stream from your portfolio. If you keep everything in a fixed interest account at 5% and you spend all the interest each year, your inflation-adjusted income will fall.
The second lesson is that keeping everything in income-producing investments is a recipe for failure. You will have to expose some of your portfolio to assets that have the potential to grow with inflation, such as stocks, commodities, and inflation-linked bonds. If you do that, and keep your withdrawal rate at a reasonable level, you will have a better chance of success.