Inflation’s impact on retirement portfolios: quantifying the future cost today

“So I think the word transitory has different meanings to different people … I think it’s probably a good time to retire that word.”—U.S. Federal Reserve Chair Jerome Powell, November 30, 2021

For most of the developed world over the last few decades, inflation hasn’t been top of mind. Since the Great Inflation of the mid-1960s to the early 1980s, the Consumer Price Index (CPI) has risen at a much more tolerable pace in the majority of the developed world, so it hasn’t been the greatest concern for consumers or investors.

But that’s changing. With inflation rates in countries across the world hitting peaks not seen in decades—including the world’s largest economy, the United States—inflation is a new reality we can no longer ignore.

Rising prices are easily noticed by consumers, since they hit us right in the wallet when paying at the pump or the grocery store. But investors and pension plan members might not notice the far more detrimental impact inflation might have on their portfolios quite as easily, since they don’t see the direct consequences on a daily basis like consumers do. Because of this, retirement savers may not have a financial plan in place to counteract inflation in the future. What’s also not well understood is how even small increases in inflation can have outsize negative impacts on retirement goals.

How much can a small increase in inflation affect you as an investor? What actions can you take now to compensate? In this paper, we discuss our forecast for inflation, quantify how much rising prices can affect investors’ retirement plans, and discuss the changes that can be made to increase the odds of reaching their goals.  

Decades-high inflation should abate, but we expect long-term inflation to be higher than before

With inflation running rampant in economies across the world, there are concerns about whether these levels represent a new normal. Our view is that this debate will soon be put to bed, and that the recent inflation prints we’ve seen are more the exception than the rule: We expect that as supply chain bottlenecks improve, CPI growth will moderate.

Our long-term views have evolved over the last couple of years. Before the pandemic, we expected inflation to average about 1.8% over the long run. Even though we think inflation will moderate toward 2% by the end of 2022, we do believe structural shifts that have taken place because of the pandemic (as well as other factors) might result in an inflation rate that’s slightly higher than what we saw in the decade following the Global Financial Crisis.

Deglobalization is one factor that we believe may contribute to higher prices going forward, but there are two others that threaten to lead to price increase as well: First, with lower participation rates and a potential labor skills mismatch, higher pressure on wages could be a factor over the long term. Second, higher oil prices could drive inflation in the long term if the supply of green energy doesn’t properly counterbalance a tightness in oil supply (despite its relatively small weighting, the change in energy prices is one of the largest contributors to changes in CPI). In all, we expect that inflation will ultimately settle somewhere slightly above 2%.

Higher inflation doesn’t necessarily mean higher asset class returns

In an ideal world, investors would be able to perfectly offset the effects of higher inflation in the future with asset classes that can deliver higher returns. But because of the murky relationship between CPI and different asset classes, relying on riskier assets alone without a corresponding change in overall risk profile may not be enough to compensate for the increase in inflation. The reason for this is the correlation between asset classes.

There’s only a moderate correlation between inflation and bond yields, for example. Over the past 40 years, we’ve seen a correlation of about 0.48 between headline CPI and U.S. 30-year bond rates (the relationship weakens as you move closer to the short end of the yield curve). Intuitively, this quasi relationship makes sense, as central banks’ most critical tool to control inflation is to raise policy rates, which would flow through to other market-determined rates.

Unfortunately, the relationship breaks down further as we head into risky assets such as stocks. In the same 40-year timeframe, the correlation with the CPI has been barely noticeable for broad U.S. equities (–0.14), U.S. growth stocks (0.17), and U.S. value stocks (0.25). The correlation does begin to look a little better for commodities (about 0.30), but not necessarily enough for us to consider them to be an ideal inflation hedging tool over the long run.  

In short, our view is that portfolio diversification is key for long-term success, but we don’t necessarily believe that asset allocation should be used as a stand-alone tool to compensate for higher inflation. 

Even small increases in inflation can have large impacts on retirement portfolios

In a world in which inflation may increase by only a few basis points (bps), should investors even be worried? And if asset allocation isn’t an ideal tool to hedge inflation away, what can be done to mitigate the effects of inflation?

We set out to answer a more specific and practical question:

If I’m X years old and plan to retire at age 65, and expected inflation increases by Y%, how much more must I invest today to receive a predetermined amount of real (i.e., inflation adjusted) income drawn from my portfolio in retirement?

To work this out, we determine the average investor’s expected-inflation duration (EID). The EID indicates how sensitive future payments from your portfolio (i.e., income drawn from your retirement portfolio) are to rising inflation: The higher the EID, the lower the real income that can be drawn from that portfolio, given a certain change in inflation.¹ As a general rule, the younger you are, the higher your EID. This makes intuitive sense, as the further you are from retirement, the more you’re affected by a higher inflation rate, since that higher inflation rate has more years to affect your portfolio.

Using the EID, we can calculate the cost of a higher inflation rate in the future on today’s investor. The cost is in terms of the change in the required portfolio today (RPT). The RPT is the amount that one must invest today in order to receive a predetermined, inflation-adjusted payment from one's investment portfolio starting from age 65 until death. For example, our model tells us that an average 30-year-old (let’s call her Donna) who wants to receive $50,000 of real income per year from her retirement portfolio starting at age 65 until her death, has an RPT of $242,257; that is, an investor who wants to receive an average of $50,000 of yearly income under current inflation conditions would need to invest $242,257 today.²

If we factor in Donna’s EID, we can calculate the likely cost that an increase in inflation has on her portfolio. This cost is the increase in the RPT that’s required because of the change in expected inflation. As a general rule, for every 1% increase or decrease in expected inflation, the RPT changes about 1% in the same direction for every year of EID.

Mathematically this rule is:

ΔRPT_% = ΔI x EID

Or, more simply:

The impact (in percent) that an increase in inflation has on a portfolio =
The expected change in inflation x The investor’s EID

Take Donna, whose EID is 47.6 and who we learned needs a $242,257 portfolio under the previous inflation conditions to meet her income needs of $50,000 per year in retirement. If expected inflation increases by 0.4%—an increase we think is entirely possible—then she'll need to increase her investment portfolio by 19.1% (0.4% x 47.6) to $288,491 in order to receive the same $50,000 of real income each year in retirement. 

So that seemingly small 0.4% increase in expected inflation? It necessitates a nearly 20% larger investment portfolio today!

One important point is that the impact of rising inflation on the investor changes with the investor’s EID, which, in turn, is affected by the investor’s age and years to retirement. For example, we can see that a 40bps increase in expected inflation raises the RPT of a 65-year-old by 5.1%, but that same 40bps increase has a 23.2% cost on a 20-year-old investor. 

Preparing portfolios for inflation could mean making some tough decisions

We can now see that even small increases in inflation can have a large impact on retirement planning. Given that asset allocation alone isn’t a sufficiently reliable hedge, investors are left with few choices for preparing.

Add money to the portfolio today

The simplest solution—although likely the hardest to actually make happen—is to inject funds into the retirement portfolio. The amount would be the difference between the RPT before and after the change in expected inflation.  

Additional capital needed = RPT_After  – RPT_Before

If Donna’s RPT was $242,257 before the expected change in inflation and is $288,491 now, the solution is to add $46,234 to her portfolio today. 

Decrease income needs

The second solution doesn’t require additional capital up front; instead, it requires that investors accept that they’ll receive a smaller income in retirement; in other words, if investors can’t put more money in their portfolio today, they can decrease the amount they receive in retirement. The decreased income can be calculated as:

Revised real income in retirement =
Prior real income in retirement / (1 + ΔRPT_%)

In Donna’s case, she would have to change her expectations for real income in retirement from $50,000 a year to $50,000/(1 + 0.191), or $41,981 annually.

Postpone retirement

The third option is to delay retirement. But for how long? This depends on the change in expected inflation and the age of the investor. If Donna (age 30) were seeking to keep her $50,000 of yearly real income at retirement without adding funds to her retirement portfolio today, she would need to retire 44 months (a little over three and a half years) later than originally planned.

Today’s new inflation reality requires new tools for retirement planning

Inflation affects us all in one way or another, and almost certainly in a negative way. Clearly, none of the solutions above are ideal or even feasible for many investors, since they involve either reduced income later, increased investment now, or working for longer.

The fact of the matter is that there’s no one-size-fits-all solution to a problem as large as rising inflation. Building a retirement portfolio takes years of planning and discipline, and even the best plans can come under stress by any number of factors, whether economic, market, or otherwise.

While we can’t control inflation or predict it with absolute precision, we can quantify both the financial toll it takes and the difficult decisions that must be made to counteract its effects. These are critical tools that are now available to investors so they can plan a comfortable retirement in a world of higher inflation.