Last Updated May 19, 2010 2:49 PM EDT
The reason inflation is such a big deal for retired investors is because you're working with a fixed pool of capital. And that capital can only produce so much in spendable distributions. If you enter a period of sustained and high inflation, it puts considerable pressure on your portfolio as you have to take larger distributions to maintain your standard of living.
While most investors think that bear markets are the biggest threat to their retirement security, history indicates that high inflation has been the main challenge. Bear markets are scary, but if you have a prudent allocation between stocks and high quality bonds, you can avoid a good portion of the damage from a bear market by simply controlling your risk profile.
But inflation hits everyone at roughly the same degree. And you can't do much to escape its effects. Consider that if inflation ran at 6% for 20 years, your distributions must grow by 320% to keep up with the rising cost of living. This means if you started your retirement by taking a 5% distribution of your portfolio value, by the end of that 20 years you'd need an annual distribution of over 16% of your original portfolio. At that rate, the odds are the money won't last long even if we have strong market returns.
But if inflation ran at only 2% for 20 years, your distributions would only need to grow by 50% to keep pace. If you started with a 5% distribution, you would only be taking out 7.5% of your original account value 20 years later. With just some modest growth in the financial markets, you could handle that distribution rate.
While there isn't much good news in the global markets this year, the low inflation rate really is the silver lining for retired investors. When we study past historical investment cycles, the period that would have caused the most problems for retired investors was the late 1960s through the 1970s. Inflation cannibalized their portfolios, and the returns from the financial markets couldn't keep up with the need for rising distributions.
- While markets unfold in different ways during every economic cycle, the data on inflation-adjusted distributions is an important aspect of retirement income planning.
Moreover, the longer inflation stays in check, the higher the odds are the economy will have a healthy recovery. So if you can maintain the bulk of your investment capital during this tough cycle, you should be in a position to benefit from the recovery in the financial markets down the road.
Bottom line. Low inflation is giving retired investors a chance to get control of their budgets and distribution needs. The less you take now, the more likely it is your money will last.
Learn More: Want to learn about a simple way to manage your personal finances and prepare for retirement, investigate my new book Your Money Ratios: 8 Simple Tools For Financial Security, available in bookstores and at amazon.com The Wall Street Journal called the book "one of the best finance books to cross our desks this year." WSJ 12/19/09.