Evaluating the Impact of Cash Distributions and Inflation on Your Retirement Portfolio
Your investment time horizon doesn’t only affect how much you need to save for retirement. It’s also important that your retirement plan account for how distributions (think: the money you take out of your portfolio to pay for things) and inflation impact your portfolio once you retire. In our experience, it’s easy to misjudge how much distributions can affect the long-term health of your investments and how much inflation affects their value.
For example, some believe that withdrawing 10% a year won’t draw down principal as equities have historically delivered roughly 10% annualized returns*—a common, but incorrect, assumption that the average is the norm. Though markets may annualize about 10% over time, returns vary greatly from year to year. Making the same withdrawals during market downturns as upswings can substantially decrease the probability of maintaining your principal. For example, if your portfolio is down 20% and you still take a 10% distribution, you will need about a 39% gain just to get back to the initial value. Wow!
Inflation can also undermine your retirement plan, particularly if it’s heavily weighted toward fixed-income products like bonds. Inflation is insidious. It decreases purchasing power over time and erodes real savings and investment returns. But because its effects are so slow and incremental, many investors fail to include it in their retirement planning.
To get an idea of how serious this is, consider: Since 1925, inflation has averaged about 3% a year.** That may not seem high, but if that average inflation rate continues, a person who currently requires $50,000 to cover annual living expenses would need nearly $90,000 in 20 years and about $120,000 in 30 years just to maintain the same purchasing power.
Exhibit 2: Maintaining Purchasing Power***
Source: FactSet, as of 03/08/2016. Assumes average annualized historical inflation of 2.90%.
Underestimating the impact of cash withdrawals and inflation is a common oversight investors make when creating their retirement plans, and it can undermine the time horizons their portfolios are able to reach. It can also be difficult for retirees to counter these effects when heavily weighted in fixed-income products, as they’ll have to absorb the costs of trading fees to shift into higher-growth investments capable of making up the lost ground. This is one reason we take a different view compared to many firms when it comes to asset allocation and advise our clients on how underperformance can also be a risk to their long-term goals.
Calculation of Other Income Sources
A comprehensive retirement plan will also consider your various sources of potential income in retirement. How much money you’ll continue to earn can make certain investments more or less attractive, depending on their tax exposure or required minimum distributions. Common categories of non-investment income to consider when planning for retirement include:
- Social Security
- Passive Income from Business Interests and Real Estate
The difference between your total income and your total expenses is your net savings. Easy, right? If your net savings is a negative number, your portfolio will have to generate enough monthly cash flow to cover the difference or it will start to shrink. We are careful to account for this factor when advising clients about their retirement plans, as it can dramatically affect which vehicles offer the best benefits.
*Source: FactSet, Inc., as of 2/11/2016. Based on annualized S&P 500 Total Return Index returns from 12/31/1925-12/31/2015
**FactSet, as of 03/08/2016; from 12/31/1925 to 12/31/2015, average annualized inflation was 2.90%, based on the US BLS Consumer Price Index
***Estimate based on a 2.90% rate of inflation.