What Inflation Really Means for Retirement Portfolios

From here, they determined the average investor’s expected inflation duration (EID), which indicates how sensitive future payments from a portfolio are to rising inflation. The higher the EID, the lower the real income that can be drawn from that portfolio, they write.

“Using the EID, we can calculate the cost of a higher inflation in the future on today’s investor,” they state.

The cost is in terms of the change in a required portfolio today — or RPT. That is the amount that must be invested today to receive a “predetermined, inflation-adjusted payment from your investment portfolio starting from age 65 until death.”

So if a 30-year-old investor today wants to get $50,000 of real income per year from their retirement portfolio starting at age 65 until death, her RPT is $242,257.

As the authors state, the basic calculation would be: The impact (in percent) that an increase in inflation has on a portfolio equals the expected change in inflation multiplied by the investor’s EID.

“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,” they state.

Therefore, if expected inflation increases 0.4%, to receive the same $50,000, the investor would need an RPT of $288,491, a 19% increase.

The authors add that the impact of rising inflation changes with the investor’s EID, “which, in turn, is affected by the investor’s age and years to retirement. For example, we can see that a 40 bps increase in expected inflation raises the RPT of a 65-year-old by 5.1%, but that same 40 bps increase has a 23.2% cost on a 20-year-old investor.”

4. Investors may need to make some tough decisions.

Due to inflation’s impact on a retirement portfolio and shortfalls of asset allocation hedging, investors have some choices, Paquet and Grassino note:

Add money to the portfolio today.

If an RPT was lower than the amount in the inflation formula, that is what should be added to the portfolio. In the example above, that would be adding $46,234 to a portfolio today.

In other words, plan to spend less. In this case, the calculation is the revised real income in retirement equals prior real income in retirement divided by one plus the change in RPT%.

Always in the mix, but how to determine how long? The authors state that it depends on the change in expected inflation and the age of the investor: If someone 30 years old was looking to keep their $50,000 yearly real income at retirement without adding funds to their retirement portfolio, they would need to retire 44 months later than planned.