The long-term impact of inflation is a fundamental risk for retirees; a 60-year-old retired couple loses 50% of their purchasing power by age 85 at a mere 3% inflation rate. To plan for this, retirement projections typically assume an annual inflation adjustment, as does the research on safe withdrawal rates and sustainable retirement income. Yet many planners are quick to point out that no clients called the office on January 1st, 2012 to request their monthly distributions be adjusted from $3,000/month to $3,090/month to reflect the 3.0% increase in CPI in 2012. In fact, most clients rarely request to adjust their ongoing portfolio distributions more than once every several years. Does that mean retired clients don’t really experience ongoing annual inflation? Or is the reality that they just handle it some other way?
The inspiration for today’s blog post is a recent conversation I had with another planner, who was questioning the assumption in the safe withdrawal rate research that clients annually increase their spending for inflation (as a part of the planner’s viewpoint that the research is overstating how client spending rises over time). The planner noted – in a very similar vein to an article by Roy Diliberto in Financial Advisor magazine last fall called "Rules of Dumb" – that in ‘the real world’ clients never adjust their portfolio withdrawals each year for inflation, and that consequently an assumption clients do so in retirement planning projections and research is wrong.
While I will certainly not dispute that clients rarely make annual adjustments to their ongoing portfolio distributions for inflation, I do not think that means clients aren’t experiencing annual inflation, though. They are. They’re simply not compensating for it by making adjustments for regular portfolio distributions; instead, the action is in the client’s bank account.
For instance, the client who spends $3,000/month might keep a checking account of $15,000, just to ensure that there’s enough cash easily available for a short-term contingency. And in general, the account balance remains relatively stable, as roughly $3,000/month of spending goes out, and $3,000 of distributions from portfolios come in (or $2,000/month, or $6,000/month, or whatever your client’s spending happens to be).
Over time, though, the checking account ends out bearing the brunt of inflation. As the client’s $3,000/month of spending rises to $3,090 with 3% inflation, over the subsequent year the average account balance falls by about $1,000 (as the almost $100/month extra spending begins to eat away). In the following year, with another few percent of inflation, monthly spending rises to almost $3,200, and the average account balance whittles down by another $2,000 or so, to about $12,000. By the fourth year of this process, monthly spending is approaching $3,400/month, and the average account balance is below $5,000. So what happens? During a review meeting with the planner, the client indicates that the checking account balance is a little low and that it needs to be replenished, and that ongoing distributions need to be adjusted, as the client is spending about $3,400/month (heading towards $3,500+/month in the coming year) and monthly distributions are only $3,000/month. The end result: a $10,000 "extra" distribution out of the portfolio after 4 years, and an increase to future monthly distributions from $3,000/month to $3,500/month.
The net result of this process is that, in reality, the client absolutely did experience ongoing inflation! It’s just that on a year-to-year basis, the brunt of it is born by the checking account and/or the client’s cash allocation of the portfolio. The rest of the portfolio catches up irregularly by adjusting once every several years, with both a lump sum distribution to replenish the checking account and a 10%-15% jump in the ongoing distribution amount to make up for years of prior inflation adjustments. Nonetheless, it means inflation is impacting the client’s spending, balance sheet, and depletion of assets from year to year.
In turn, this also means that if we really want to get a handle on whether or how much inflation clients are experiencing, it’s necessary to look at changes in the checking/savings account balances over time, not just whether or how often clients change their recurring portfolio distributions. To get a realistic handle on this, it’s probably appropriate to look on a yearly basis and see if there’s been a change in the overall bank account balances (yearly is preferable, as month to month fluctuations are likely to occur for most clients, simply due to the timing of expenditures and the irregularity of certain expenses throughout the year).
But the bottom line is the fact that clients might not adjust portfolio distributions on an annual basis doesn’t mean they’re immune to inflation and that changes to the CPI don’t affect them. It simply means that they’re probably handling the smaller incremental changes over time from their bank account, and making it up infrequently with bigger adjustments over multi-year periods of time. Which also means that when looking holistically at the client’s plan and balance sheet, annual inflation assumptions in retirement projections are not invalidated just because recurring portfolio distributions aren’t changing every year.
So what do you think? Are your clients experiencing the impact of annual inflation? Is CPI is a fair measure for the average inflation your clients feel over time? Is the bank account phenomenon a fair characterization of how your clients handle short-term inflation? Do you monitor changes to your clients’ bank account balances from year to year to keep track of the impact of inflation?