How to Stop Inflation From Wrecking Your Retirement

(Bloomberg Opinion) -- Inflation is why the 4% rule never made any sense.

I've always found it strange that we put one of the most complex and difficult financial problems on senior citizens. After you retire it's very hard to know how to invest and how much to spend each year. You must plan around many unknowns, how long you’ll live, what you’ll need to spend on health care and what will happen to markets. Saving while working is the easy part, but spending down a retirement nest egg is much, much harder, and leaves much less margin for error. It also gets much less attention from the finance industry and policy makers.

Enter the 4% rule, the idea that if you spend 4% of your assets each year you’ll have enough to last you through retirement. It was a well-intentioned effort to reduce the complexity to one simple guideline. But it's deeply flawed, and that's become all the more apparent as inflation creeps up and poses another source of risk to retirement income.

The original 4% rule dates back to 1994, It dictated that a retiree invest their assets in a 50/50 stock/ intermediate bond split, take out 4% the first year, and adjust that amount for inflation thereafter. But 10-year treasury yields were more than 7.5% in 1994. As rates fell and stayed low, that 4% rule no longer seemed like a sure bet. At the time the rule was created, having such low yields for so many years was unthinkable. Up until several months ago many people couldn't imagine high inflation either. This is the problem with simple rules for complicated problems. They don’t hold up well when the unimaginable happens, and in markets the unimaginable is to be expected.  

That's why Morningstar just announced 3.3% is the new 4%. The investment research firm assumes inflation will be low going forward, but is concerned that bonds will stay low and equities are over-valued. The new rule means that if you have $1 million saved, your income is cut to $33,000 a year from $40,000 — which is a significant drop in your standard of living. Accepting that markets are full of surprises, they suggest retirees adjust how much they withdraw each year based on how the market does: when the market is up, spend a higher percent, when it's down, spend less. This is even worse than the old 4% rule, because it makes a basic and fundamental error.

The objective is not to avoid running out of money before you die, as the spending rule assume. The goal is to be able to finance your retirement with some degree of predictability. Not running out of money is the constraint, not the objective. The average worker puts a high value on stable wages, yet for some reason the financial industry assumes retirees are content to endure large swings in their income year to year.

If you are in a 50-50 stock/bond allocation, the Morningstar strategy may result in more than 30% income swings years to year, and that isn’t even accounting for the new inflation environment. Yet most retirees are on a fixed income and have large health expenses.

If predictability is part of the objective, it will take more than a 50/50 split and a simple rule, it requires actively managing market and inflation risk. One option could be buying an annuity that will pay you a fixed amount each year, leaving the insurance company to take on all the risk. But the annuity market is thin in America and it's hard to find one that will adjust income for inflation. People also hate annuities. When the U.K. required people to buy them it proved so unpopular that the government backed down and left British people as lost as the rest of us. Another popular idea is spending the Required Minimum Drawdown (RMDs), which is how much retirees are forced to withdraw from their accounts each year to avoid a tax penalty. But these were never intended to be a spending plan and Morningstar estimates a spend-RMD rule can lead to 50% swings in income year to year.

A better option is to delay Social Security as long as possible so the government will pay you a bigger benefit. The government not only pays a certain amount each year, it will adjust it for inflation. For their remaining assets, retirees also need to be more proactive in their risk strategy and get serious about inflation protection. Instead of short-term or medium-term nominal bonds in their fixed income portfolio, retirees should seek out longer-term bonds that are inflation-adjusted with payouts that will match the income they need each year.

Such bonds are very expensive, so many retirees can’t afford this approach. That leaves taking a hard look at spending and thinking through needs and wants. One strategy is to finance needs — ousing, gas, food — with safe assets such as Social Security and inflation-indexed bonds, which both offer protection in a high-inflation environment. This is critical because the price of the goods you need tend to be more sensitive to inflation. After that, finance wants — vacations or presents for the grandkids — by drawing down assets from your riskier portfolio that's invested in stocks and might vary year-to-year based on asset performance.  

Inflation is the new risk to retirement. It may change bond yield and equities in unpredictable ways, and erode the value of any assets that aren't inflation-protected. Relying on the old rules, which were flawed to begin with, will no longer be sufficient.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Allison Schrager is a Bloomberg Opinion columnist. She is a senior fellow at the Manhattan Institute and author of "An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk."

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