Morningstar - Q2 2021 - 40

Strategies

EXHIBIT 2

Coping With Inflation

How Portfolio Mix Affects the Odds The more equity exposure, the greater the
chances of success.
100% Bonds
75% Bonds/25% Stocks

50% Bonds/50% Stocks
25% Bonds/75% Stocks

100% Stocks

Probability of Success
100%

There are few signals of runaway inflation
today, and few real catalysts for it. Inflation
may return to more normal levels of 3% or so,
but few are expecting the sort of inflationary
spiral of the 1970s and early 1980s.
Still, the possibility-but not the certainty-
of higher inflation embellishes the case
for taking a more conservative approach to
in-retirement withdrawals than what may have
been warranted before. It also argues for
investors taking a close look at other tools at
their disposal to ensure that a spike in
inflation doesn't imperil their portfolio's ability
to last throughout their retirement.

80
60
40
20
0
2.0
2.5
3.0
3.5
4.0
Spending Rate (% of Initial Portfolio Value)

4.5

5.0

5.5

6.0

6.5

7.0

Source: Morningstar.

One tool is Social Security, especially for lowerincome retirees. Social Security is inflationadjusted and points to the importance of
thinking holistically about a retirement plan in
the context of inflation rather than focusing
exclusively on portfolio withdrawals. One
of the reasons that planners argue for healthy
people to delay Social Security is not just the
larger benefit that comes with waiting, but
that the larger benefit is also inflation-adjusted.
Another idea is to reduce the vulnerability
of retirees' spending to higher inflation.
The decision about whether to buy a home or
rent one is obviously about much more
than inflation, but a major financial benefit
of homeownership is not having such a big
expense buffeted around by inflation.
Finally, retirees' investment portfolios should
play a role in guarding against inflation. That's
why my model " bucket " portfolios include
ample exposure to assets that have some
ability to hedge against or outearn inflation
over time. Treasury Inflation-Protected
Securities fit into the former camp and equities
into the latter.
Christine Benz is Morningstar's director of
personal finance.

40

withdrawal rates over a 30-year horizon. He
then ran a Monte Carlo analysis to randomly
generate 10,000 potential return paths
for each spending rate to generate a range of
scenarios and estimate the probabilities
of different outcomes.
As shown in EXHIB IT 1 , these assumptions lead
to a slightly lower sustainable withdrawal
rate for a portfolio combining 50% stocks and
50% bonds. An investor looking for a 90%
probability of success wouldn't quite get there
with the traditional 4% initial withdrawal
rate, but ratcheting starting withdrawals
down to 3.5% improved the odds. The table also
shows the average length of the shortfall
for portfolios that ran out of money before the
end of the 30-year period.
Portfolio mix is another important factor.
Increasing the portfolio's equity allocation can
improve the odds of success, as shown
in E X H I BI T 2 . Conversely, bond-heavy portfolios can
put a damper on sustainable withdrawal rates.
Depending on their level of comfort with equity
market volatility, retirees can use equity
exposure as a lever to allow for slightly higher
withdrawal rates.

Of course, this analysis comes with a couple
of major caveats. Longevity is inherently uncertain,
so most retirees can't predict how long they'll
need their money to last. And even if we could pin
down an accurate return number, how retirees
ultimately fare depends on a multitude of factors,
including the sequence of returns. A negative
sequence of returns during the first few years of
retirement can be especially detrimental.
Start Conservatively
That means it's important to monitor market
conditions and portfolio values. Most retirees don't
set a fixed withdrawal amount that they follow
year in and year out no matter what. Instead,
investors can improve their results by following a
flexible withdrawal strategy, such as not
adjusting withdrawals for inflation in years after
a negative market return or limiting withdrawals to
a certain percentage of the portfolio's value.

Still, investors need a starting point. For retirees
who plan to start taking withdrawals soon,
it's reasonable to be on the conservative side with
assumptions for future returns. K
Amy C. Arnott, CFA, is a portfolio strategist
with Morningstar.
Morningstar - Q2 2021

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