#4: What do you expect the inflation rate to be?
Inflation is the single-most dangerous figure for would-be retirees because it is the one they never see coming. Inflation creates a nightmare scenario: Your expenses rise while your income remains fixed.
The news here isn’t good. One of the easiest ways — or most cowardly, depending on your point of view — for the government to reduce its Social Security liabilities is to tinker with or eliminate cost-of-living adjustments. It’s a stealth form of taxation and one that hits retirees particularly hard.
To play it safe, we should assume that your Social Security payout will be constant — with no inflation adjustment at all. This means your investment portfolio will need to generate enough to make up the difference.
The math here can get a little cumbersome, but bear with me.
If you assume an inflation rate of 3%, your $100,000 per year in living expenses will be $103,000 after the first year. This means your portfolio will need to generate $67,000 instead of $64,000 (remember, we’re assuming no adjustment from Social Security). On the same $1.5 million portfolio, this means a required after-tax return of 4.5% rather than 4.3%, and a pre-tax return of 6.25%.
That might not sound like much, but remember that inflation is like interest — it compounds over time. By year two, you’re looking at expenses of $106,000 … and a required pre-tax return of 6.5% on that same $1.5 million portfolio.
To compensate for this, you need portfolio growth and (more importantly) adequate exposure to income-producing asset classes that have built-in inflation protection — things like REITs, MLPs and certain dividend-paying stocks.
More than anything, you need a margin of safety. You need a little bit of “wiggle room” in the event that your investments don’t generate as much income as expected or in case inflation is higher than forecast.
I used very conservative numbers in this article, but I encourage you to do the same. It’s better to be too conservative and end up with a bigger cushion than expected in retirement than to find yourself strapped for cash and forced to give up that house on the golf course.
Charles Lewis Sizemore, CFA, is the chief investment officer of the investment firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Click here to receive his FREE 8-part investing series that will not only show you which sectors will soar but also which stocks will deliver the highest returns. The series starts November 5 and includes a FREE copy of his 2014 Macro Trend Profit Report.