For decades, retirement planning has assumed inflation would average around 2-2.5% annually, and financial planners built withdrawal strategies, income projections, and spending budgets around this number. Then 2021 happened, then 2022 happened, and suddenly the world saw inflation numbers hovering around 7%, 8%, and even 9% depending on where and how it was measured.
Thankfully, inflation has cooled off from those levels, and today it’s hovering right around 3%, rather than even higher, even though the Fed did promise a 2% inflationary number. While a 1% difference over the course of a year might sound small, compound this number over a 25-30 year period during retirement, and it’s the difference between your money lasting and running out a decade earlier than planned.
The math is pretty brutal if you start to dive into it. At a 2% inflation rate, your purchasing power is cut in half over 35 years, while at 3%, it cuts in half over 24 years, and at 4%, it’s 18 years. In other words, if you retire at 60 with what feels like a lot of money and inflation stays constant around 3-4% for the next two decades, you’ll be 80 years old with half the buying power you started with and arguably another decade or more of living without the necessary fund levels.
How Persistent Inflation Destroys Fixed-Income Plans
Traditional retirement plans will assume you can withdraw a fixed percentage adjusted for inflation, but those models will break down if inflation runs hotter than anticipated. Trying some math again, consider retiring with $1 million and withdrawing $40,000 annually according to the 4% rule, which would normally be adjusted in the second year of retirement to $40,800 at 2% inflation.
However, if inflation is running at 3.5%, you will then need $41,400 to maintain the same level of purchasing power as you did in year one. The extra $600 might not sound like much, but multiply it across 20 or 30 years, and the withdrawals compound significantly higher than the original plan assumed.
The problem accelerates because your portfolio might not be growing fast enough to support higher inflation adjustments. If your portfolio returns 6% annually but inflation is at 3.5%, your real return is only 2.5%, something many retail investors tend to forget. After withdrawing this inflation-adjusted number for expenses and cost of living, there is less left for the portfolio to compound on.
Ultimately, this means that the math is going to catch up to you, and if you are withdrawing more each year, even nominally, your portfolio will not be growing as fast as necessary to support your lifestyle, and the principal erodes faster than any models might have predicted.
The Assets That Protect Against Inflation (and Those That Don’t)
If inflation is structurally higher than the 2-2.5% assumption, the amount you need to retire comfortably has to increase as well. The old rule of thumb might have suggested that you need 25 times more than annual expenses, based on the 4% rule, which assumed 2%^ inflation. If inflation averages 3.5%, you now need closer to 28-30 times annual expenses to maintain the same lifestyle over a 30-year retirement.
Rest assured, this isn’t a small difference when you consider that instead of $1 million you thought you needed to retire, it’s more like $1.2 million to have the same margin of safety. To navigate this, the best option is to adjust your withdrawal rate down from 4% to something like 3.5% or even 3% if you expect inflation to run hotter than expected during retirement.
Lower withdrawal rates reduce the sequence-of-returns risk and leave more room for the portfolio to grow enough to support larger inflation adjustments down the road. This means either saving more before retirement, working a few years longer, or building a bigger nest egg, as mentioned above. The only other option is to really consider adapting to a lower standard of living, which most retirees don’t want to even consider.
How to Adjust Your Plan If You’re Already Retired
For retirees who are already living off their portfolios, persistent inflation above 3% requires something of an immediate adjustment, instead of just hoping and wishing for inflation to lower closer to 2%. The first step to take is shifting portfolio allocation away from cash and bonds and more toward assets with inflation protection already built in.
This doesn’t mean selling everything and buying gold, it means reducing exposure to long-duration bonds and increasing allocations of investments like growth stocks, REITs like NNN REIT (NYSE:NNN), and Realty Income (NYSE:O) that offer inflation-adjusted leases, and I-Bonds or TIPS that explicitly protect against inflation.
Another adjustment is to consider some spending flexibility, especially if your plan assumed 2% inflation and it’s actually closer to 3.5%, so something has to give. You can’t just withdraw 3.5% more each year indefinitely, as you will run out of money. This leads back to the idea that you might have to cut discretionary spending during years when inflation is hotter than normal, as well as delaying big purchases like a new vehicle, home, or travel.
Alternatively, some retirees might have to consider generating supplemental income through part-time work or consulting. The retirees who will successfully navigate high-inflation environments are those who treat their withdrawal plans with flexibility rather than rigidity. When inflation surprises to the upside, you just adjust spending down temporarily and preserve capital. When inflation is more moderate, you can afford to be less restrictive.