Wednesday, June 5, 2019

Inflation and the four percent rule



This post considers how an increase in inflation impacts the viability of the four percent rule.   The basic financial scenario considered here is a pessimistic one.  It involves low returns at the beginning of retirement and higher returns in subsequent years.

Question:  Consider a worker who retirees with $500,000, sets an initial disbursement at 4 percent of assets and links disbursements to inflation.

Market returns are -6 percent for the first four years followed by 9.0 percent per year for 11 years.

What is ending balance of the account assuming inflation rates of 2.0, 3.0, 4.0, 5.0 and 6.0?

The Basic Spreadsheet


The basic spreadsheet with a 2.0 percent inflation rate assumption is presented below.

Scenario One
Initial Disbursement Rate
0.04
Inflation Rate
0.02
Balance
Disbursement
Stock Returns
0
$500,000
$20,000
1
$450,000
$20,400
-0.06
2
$402,600
$20,808
-0.06
3
$357,636
$21,224
-0.06
4
$314,954
$21,649
-0.06
5
$321,651
$22,082
0.09
6
$328,518
$22,523
0.09
7
$335,561
$22,974
0.09
8
$342,788
$23,433
0.09
9
$350,206
$23,902
0.09
10
$357,822
$24,380
0.09
11
$365,646
$24,867
0.09
12
$373,687
$25,365
0.09
13
$381,954
$25,872
0.09
14
$390,458
$26,390
0.09


Discussion of Spreadsheet:


The disbursement rate top cell in input area is multiplied by initial balance $500,000 top row of chart to get initial disbursement.

Subsequent disbursement is (1+inf)*previous period disbursement.

Stock returns are in far-right column.

Balance is (1+return) * previous balance) – previous disbursement

To obtain ending balance at other inflation rates just input the other inflation rate and recalculate the spreadsheet.

The Impact of inflation on 401(k) Balance


The chart below summarize the impact of inflation on the 401(k) balance under the four percent rule under the assumed financial scenario.

inflation Rate
Ending Balance
0.02
$399,210
0.03
$360,863
0.04
$319,403
0.05
$274,560
0.06
$226,042


The simulation reveals assets fall sharply with an increase in inflation under this four percent rule and under this financial scenario. 








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