The New Finance Of Longevity

Quantifying The Future Cost Of Today

Inflation’s impact on retirement portfolios

by Emilie Paquet and Alex Grassino

Ms. Paquet is Managing Director, Head of Financial Engineering at Manulife Investment Management.
Mr. Grassino is Head of Macro Strategy, North America, Multi-Asset Solutions Team at Manulife Investment Management.

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. But that’s changing. Rising prices are easily noticed by consumers. But investors might not notice the far more detrimental impact inflation might be having on their portfolios quite as easily, since they don’t see the direct consequences on a daily basis. 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.

Even Small Increases In Inflation Can Have Large Impacts On Retirement Portfolios

We set out to answer a 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 retirement portfolio?

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]

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 you must invest today in order to receive a predetermined, inflation-adjusted payment from your investment portfolio starting from age 65 until death. For example, our model tells us that, let’s say Donna, an average 30-year-old 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. 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

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...

Take Donna, whose EID is 47.6 and who we learned needs a $242,257 portfolio under the old 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 in order to receive the same $50,000 of real income each year from age 65 until death, she now needs approximately $288,491 (i.e., a 19.1% increase, or 0.4% x 47.6) instead.

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

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, a 40bps increase in expected inflation raises the RPT of a 65-year-old by 5.1%, but a 40bps increase has a 23.2% cost on a 20-year-old investor.

Preparing Your Portfolio For Inflation Could Mean Making Some Tough Decisions

Add Money To The Portfolio Today

The simplest solution 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 = RPTAfter – RPTBefore

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 requires that the investor accept that they’ll receive a smaller income in retirement. If the investor can’t put more money in their portfolio today, they can decrease the amount they would 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. 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.

Simply stated, today’s new inflation reality requires new tools for retirement planning. 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 can now be provided to investors so they can plan a comfortable retirement in a world of rising inflation.

 

 

 

[1] In calculating the EID, we assume a fixed expected return on assets such as equities and bonds.