We all share a common goal: to grow our nest eggs and make sure they last over the long haul. Our generation was taught to live off the interest and never touch the principal, but interest rates for CDs and Treasuries no longer allow for that. Frankly, they don’t even keep up with inflation, so we have to invest our money elsewhere if we want it to last.
It is a challenge to keep up with inflation and earn enough income to supplement our Social Security. Also, when our respective parents died, my wife and I each inherited a bit of money to add to our retirement fund, and we hope to do the same for our children. Many of you likely have a similar goal.
In 2007, an investor with $1 million could earn $60,000 annually on a certificate of deposit. Today, that same CD would earn $12,000, which makes things a lot more difficult. We will use $1 million in our examples simply because it’s an easy number to follow and do math with in our heads. However, the principles we’ll discuss apply no matter what size your retirement portfolio happens to be.
The Old Rule of Thumb
Back in the good old days, there were four estimates that worked well for conservative retirement planning:
- Return on your portfolio: 6%
- Inflation rate: 2%
- Age your money needs to last to: 120 years old
- Percentage of your portfolio to invest outside of CDs and high-quality bonds: 100 minus your age at retirement
Will 100 Minus Your Age Work Today?
A retiree who invests 65% or more of his or her nest egg in Treasuries or CDs will not earn enough to keep up with inflation, let alone pay the bills. Furthermore, while fixed-income investments were once considered safe, they carry significant risk, as rising inflation rates could destroy their value. So, retirees are under a two-sided attack.
How Should We Factor in Inflation?
This is really a twofold question: what is the inflation rate; and how does it affect our personal buying power?
Regardless of what the inflation rate is, to maintain the buying power of our nest egg, our principal must be adjusted every year. If we have $1 million and plan for 4% inflation to leave a little room for error (that’s a little over twice the official September 2013 annual rate), we need to earn $40,000 at the end of the year to cover inflation. Anything above that is supplemental income, or we can keep it in our portfolio.
There has been a lot of discussion about what the real rate of inflation actually is. The Bureau of Labor and Statistics’ (BLS) formula is quite complicated, and takes into consideration housing costs, food, and health care, etc. However, the BLS inflation rate can seem irrelevant when your costs are increasing much faster than it suggests they should.
In our reader poll, folks estimated their personal inflation rate at 8.1%, on average. Using that number, you would need to earn $81,000 on $1 million dollars just to stay even. Depending on your personal expenses, inflation will affect you differently. So, take a good look at your expenses and find a reasonable rate that suits the rising costs in your life.
Inflation varies from year to year. Most folks think the increase to our 2013 Social Security checks did not even come close to covering the true inflation rate for 2012. While inflation over the last 30 years may have been 2-3%, it is much better to err on the side of caution. I’d rather overshoot the number than not. So, set a reasonable inflation target that’s somewhere above the official 2.0% rate.
Personally, I believe there is a commonsense rule that applies. A few years ago my wife Jo and I had a terrific year, with overall returns in excess of 25%. When that sort of windfall occurs, a retiree who wants to stay retired will use some common sense and not go on a spending binge. They will take out only what they need to meet regular expenses and leave the balance in their portfolio to grow. When a lean year comes along, we may fall a percent or two short. Life is much less stressful if during most years we bank a little extra to build a cushion.