What Inflation Really Means for Retirement Portfolios

Perhaps retiring the word “transitory” when it is used with inflation would be smart, as per Fed Chairman Jerome Powell’s comment in November 2021. But no matter if it’s transitory or not, inflation will continue to affect retirement portfolios for now, according to Emilie Paquet, head of financial engineering at Manulife Investment Management, and Alex Grassino, Manulife’s head of macro strategy, in a recent paper.

According to the duo inflation “is a new reality we can no longer ignore,” and investors need to understand how it will affect their retirement portfolios.

Here are four points they highlighted in the paper:

1. Inflation will settle, but at slightly higher levels.

Could this rampant new inflation be a “new normal”? No, the team writes, noting that current inflation rates will be more “the exception than the rule: We expect that as supply chain bottlenecks improve, CPI growth will moderate” toward 2% by the end of 2022.

But due to “structural shifts” that happened during the pandemic, inflation likely will remain higher than what was seen in the decade after the 2007-2009 global financial crisis.

Three main factors will drive higher inflation: deglobalization, higher pressure on wages and higher oil prices. The result, they say, is “we expect inflation will ultimately settle somewhere slightly above 2%.”

2. Higher inflation doesn’t necessarily mean higher asset class returns.

Higher inflation probably won’t be offset by higher returns, they note, largely due to “the murky relationship between CPI and different asset classes,” and investing in riskier assets won’t be enough to “compensate for the increase in inflation.”

Key to this is a “moderate correlation between inflation and bond yield,” which the duo says has been about 0.48 over the past 40 years. But that breaks down as investors head into risky assets such as stocks, they write. The correlation of the CPI with broad U.S. equities is -0.14, U.S. growth stocks 0.17 and U.S. value stocks 0.25, they note. For commodities it is 0.30.

Paquet and Grassino see portfolio diversification as the key to long-term success, “but we don’t necessarily believe that asset allocation should be used as a stand-alone tool to compensate for higher inflation.”

3. Even small increases in inflation can make a large impact on retirement portfolios.

So how to mitigate the effects of inflation on a retirement portfolio? In a word problem, they asked: “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?”

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.

• Decrease income needs.

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%.

• Postpone retirement.

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.