How to Stop Inflation From Wrecking Your Retirement

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.