How Does Inflation Impact Retirement?

Though the rate of inflation has decreased over the past two years from a high of 9%, many consumers are still worried about rising prices. This is especially true for retirees, who don’t have the ability to earn more money and offset an increased cost of living.

But how much does inflation actually impact retirees? Is it better to have high inflation earlier or later in retirement? And, most importantly, what can retirees do to ensure they don’t run out of money as they face rising prices?

I will answer all of these questions and more as I explore the impact of inflation on retirees. I plan on doing this by analyzing three hypothetical scenarios: high inflation early in retirement, high inflation in the middle of retirement, and high inflation later in retirement. By understanding how inflation impacts spending over the retirement lifecycle, you will be better prepared to deal with rising costs in old age.

So, whether you’re already retired or still in the planning stages, it’s essential to consider the role inflation can play in your golden years. To that end, let’s start by looking at what high inflation actually means.

How High is “High” Inflation?

Before we analyze how inflation impacts spending in retirement, we first must choose a period of “high” inflation. Below is a chart showing the annual inflation rate in the U.S. from 1927 to April 2024:

Annual inflation rate from 1927 to 2024.

Over this time period, the annual inflation rate in the U.S. was between 0% and 5% around 66% of the time. The other one third of the time, inflation was above 5% or below 0% (i.e. deflation). While there is no official definition of “high” inflation, I would say anything above 10% clearly qualifies. Looking at the chart above, there are only two periods that meet this criteria: the mid-1940s and the mid-1970s. 

When I analyzed these two periods to look at the impact of inflation during the early, middle, and later parts of a 30-year retirement, I found that the mid-1970s were a better choice. Why? Because those that reached the later stage of retirement in the mid-1940s had to retire in the mid-1920s and face The Great Depression.

Unfortunately, this once-in-a-century event biases the results far more than the inflationary period of the mid-1940s ever could. As a result, if we want a somewhat cleaner comparison of high inflation across the retirement lifecycle, we have to choose the mid-1970s.

As a result, I chose 1974 as my “early” inflation retirement date, 1964 as my “middle” inflation retirement date, and 1954 as my “late” inflation retirement date. In doing so, I ensured that all of these retirements experienced the exact same high inflation of the mid-1970s to early 1980s, but at different points in the retirement cycle.

Those retiring in 1974 experienced this inflation in their first 10 years of retirement. Those retiring in 1964 experienced it in their second 10 years. And those retiring in 1954 experienced it in their final 10 years.

After doing this, we can then determine whether experiencing inflation earlier or later is better for the typical retiree. Let’s turn to that now.

How Does Inflation Impact Spending Across Retirement?

Now that we have defined our period of high inflation to analyze, let’s look at how this inflationary period impacted spending for a typical retiree. To do this, I assumed that all retirees started with a $1 million portfolio and utilized the 4% Rule.

As a reminder, the 4% Rule states that you spend 4% of your portfolio value in the first year and adjust this spending amount for inflation every year thereafter. In this case, whether someone retired Early (1974) or Late (1954), they both start their retirements spending $40,000 a year and adjust based on inflation over time. Note that while in retirement, their money is invested in a 60/40 U.S. Stock/Bond portfolio and is rebalanced annually.

Plotting the annual retirement spending during these three periods [“Early (1974)”, “Middle (1964)”, “Late (1954)”] alongside a low inflation control period [“Low (1990)”], we would see the following:

Annual Retirement Spending based on the inflation regime.

As you can see, what matters the most when it comes to spending in retirement is the total inflation experienced over retirement. It’s not just one inflationary period that matters, but the cumulative impact of inflation that effects your spending.

This explains why the “Early” line rises first, followed by the Middle, then Late line. As each retirement window experiences the period of highest inflation (1974-1984), the annual spending rises accordingly. The one exception to this is the “Low (1990)” retirement period which was a 30-year period of lower overall inflation (1990-2020).

What this means is that you don’t need to worry about a spike in inflation, but sustained inflation over long periods of time. This continuous inflation will have a far bigger impact on your overall spending.

But, spending alone doesn’t tell you whether you will have a difficult retirement. After all, if your portfolio rises enough, it can offset higher prices. So, how does inflation impact your overall portfolio in retirement? Let’s see.

How Does Inflation Impact Your Portfolio in Retirement?

Now that we’ve looked at spending in retirement across different inflation regimes, let’s see how your portfolio would’ve have fared under each scenario. Below I have plotted the portfolio value across our three retirement periods of interest [“Early (1974)”, “Middle (1964)”, “Late (1954)”] and the low inflation control period [“Low (1990)”] using a 4% withdrawal rate:

Retirement portfolio value across multiple inflation regimes with a 4% withdrawal rate.

With a 4% withdrawal rate, a 60/40 portfolio would not run out of money across any of the retirement periods listed above. However, the final outcomes do vary widely.

But what is the cause of these differences? Not inflation. It’s market performance. Yes, you read that correctly. While inflation can have a negative impact on your retirement, the market’s overall performance matters more.

We can see this in the image above since both the “Early (1974)” and “Late (1954)” inflationary periods ended up with more money than the low inflationary period of 1990-2020. This suggests that market performance can more than offset the effects of high inflation.

You can see this clearly if you look at the “Early (1974)” period which started off behind, but then experienced the greatest 20-year period in U.S. stock market history (1980-2000). By entering into the DotCom bubble during its last 10 years of retirement, a 1974 retiree would’ve ended up with far more money than the others. Similarly, though the “Low (1990)” period experienced less inflation than the other periods, it also experienced one of the worst 10-year periods in U.S. stock market history from 2000-2010.

Putting this altogether and you can see why luck plays such an important role in your lifetime financial outcomes. However, there is one variable in your control that can influence your “luck” in retirement—how much money you spend.

For example, imagine we ran the same retirement simulations as before, however, this time we used a 6% withdrawal rate instead of a 4% withdrawal rate. This means that our retirees would start out spending $60,000 per year and adjust it for inflation, instead of starting out spending $40,000 a year. Overall, total retirement spending would be 50% higher with a 6% withdrawal rate compared to a 4% withdrawal rate.

If we were to do this, what would happen? Would our “Early (1974)” retiree still end up with the most money when using a 6% withdrawal rate? Nope. In fact, someone retiring in 1974 while withdrawing 6% annually would go broke in under 30 years.

To see this, we can plot the same four retirement simulations, except while using a 6% withdrawal rate:

Retirement portfolio value across multiple inflation regimes with a 6% withdrawal rate.

In this scenario the “Early (1974)” and “Middle (1964)” scenarios both run out of money during the last 10 years of retirement. How is this possible? Because the timing of your spending in retirement matters.

So if you spend too much of your portfolio too early, it may enter into a financial death spiral that it will never escape from. This is what happened with the Early and Middle scenarios above. The Middle scenario already struggled (relative to the other scenarios) with a 4% withdrawal rate. However, when we increase the withdrawal rate to 6%, the brutal stock market of 1966-1982 prevents the portfolio from staying afloat. Long story short, you get the financial death spiral.

The same thing happens in a different way for the Early (1974) scenario. Because it spends so much money early on, even when it starts to earn fantastic returns in the 1990s, it’s too late. The spending overtakes the income generated by the portfolio and it goes to zero.

While these high inflation scenarios might seem scary for anyone approaching retirement, there is an easy way to fight back.

How to Fight Back Against High Inflation

While we can’t control how much things will cost in the future, if you find yourself battling against inflation, there is one tool always at your disposal—how much money you spend. Unlike the retirement scenarios above, you can adjust your spending over time

As much as I love running retirement scenarios using the 4% Rule, this is where they fall short. The 4% Rule assumes that retirees are robots who indiscriminately increasing their spending with inflation each year. Unfortunately, all the empirical evidence suggests that this isn’t how retirees behave. If anything, retirement spending tends to go down over time, not up. As I stated in Just Keep Buying:

Researchers at the Center for Retirement Research demonstrated…that spending in retirement typically declined by about 1% per year.

If this is the case, then inflation may be less of a worry than you initially imagined.

But even if you don’t decrease your spending over time, there’s nothing stopping you from adjusting your spending when necessary. As I’ve shown previously, you can spend more money in retirement if you are flexible. The trick is to not withdraw as much from your portfolio when its in a large decline. In other words, don’t kick your investments while they’re down.

If you can embrace this idea, then you don’t need to worry as much about running out of money in retirement. This is especially true if you experience a period of high inflation. After all, the best way to fight back against higher prices is not to pay them! While this is easier said than done, a little flexibility in your spending can go a long way in retirement.

Thankfully, for current or soon-to-be retirees our most recent episode of high inflation seems to be over. Until the next one, happy investing and thank you for reading!

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