Does High Inflation Destroy the 4% Rule?

“Your cash is melting like ice in the sun.”

Or so say some financial advisors when referring to the current level of inflation.

Inflation is a constant tax, of course, making your money worth less and less as time goes on. When under control, it’s more like a mosquito bite, itchy and annoying but ultimately not harmful.

But when inflation starts to get out of control, problems abound.

What’s a retiree to do, withdrawal-wise, in an era of high inflation? How have similar conditions worked out in the past?

Let’s take a look.

This post from Bryce was originally published on Millennial Revolution.

Move over, coronavirus. After dominating the news for 2 years straight, the buzzword that has now taken over the financial media is no longer the dreaded C-word, but the dreaded I-word: Inflation.

Inflation used to be something we read about in history books. Well, not anymore. With inflation hitting 20-year highs all around the world and everything from a tank of gas to a package of hot dogs becoming more expensive than it was even a few months ago, all of a sudden inflation is the issue that everyone’s talking about.

So let’s talk about it here.

Over the next few weeks, we’ll be doing a series of articles about the impact of inflation on the FIRE community. While FIRECracker combs through her spreadsheets to measure how inflation has (or hasn’t) impacted our personal spending levels, she suggested I do, in her words, “one of my nerdy dorkmeister articles.”

So I thought I’d try to answer a question that people have been sending me, in my trademark “nerdy dorkmeister” way. Namely, with the value of money eroding and everything getting more expensive, does the math behind FIRE still work?

It’s a question that many of you have been wondering, and with good reason. Millennials have never dealt with high inflation before, or rising interest rates. And as recent stock market volatility has shown, we have reacted the same way humans have reacted to things they’ve never seen before for eons: by freaking the f*** out.

What happens if you retire in a year with high inflation? Does that screw over your FIRE plan? Do you run out of money and are forced to live in an alley somewhere eating cat food?

*shrug* I don’t know!

But let’s find out, shall we?

The Gold Standard

As I started my research for this article, my original idea was to comb through the stock market data going all the way back to 1900 and identify the periods where inflation was the highest. As I started playing around with the data, though, I realized that the story of inflation (and the techniques used to fight it) has evolved over the last century. At the beginning of the 20th century, politicians and economists really didn’t know what to do with inflation, and as a result made some decisions that, while they seemed like they made sense at the time, actually made the problem worse.

For example, during the Great Depression that started in 1929, the Hoover administration responded to a contracting economy by adopting protectionist trade policies to keep jobs in the US, as well as cutting government spending. This made the Great Depression worse, causing it to last a brutal decade, only ending at the beginning of WWII.

It took the US government many decades (and a few more wars) to figure out how to combat recessions, namely by counter-intuitively lowering taxes and going into deficit spending in order to stimulate the economy.

Something similar happened to inflation. Inflation, in the best of times, is a confusing topic to grasp for any economist, but in the early 20th century the people running things were really just trying random things to see what worked and what didn’t, with varying degrees of success.

Collectively, we seem to have figured out the trick to corralling inflation around 1973, because that’s when President Nixon took the US off the gold standard.

You’ve probably heard your parents or grandparents wax nostalgic about the gold standard because it supposedly made money “more real,” but I’m honestly not sure why it was so great. In a nutshell, the gold standard made each dollar exchangeable for physical gold at a fixed price. The point of this was to limit the number of dollars in circulation since the money supply was limited to how much gold the US had in its possession. This would theoretically prevent inflation from ever happening, but the gold standard failed miserably in this regard as inflation managed to rear its ugly head anyway in 1941, 1946, and 1950. And because the gold standard didn’t allow the government to adjust the supply of money, there wasn’t an easy way to get inflation under control when it happened.

By the 60s, economists had figured out that interest rates were the key to corralling inflation. When inflation is high, raising interest rates would counteract it, and vice versa.

In 1973, Nixon officially abolished the gold standard, giving central banks the ability to set interest rates to fight inflation. After that, periods of high inflation still existed, but they could be controlled.

For that reason, the most relevant period of time we’re going to look at when examining periods of high inflation is 1973 to the present. You can agree or disagree with Nixon’s decision to abandon the gold standard, but regardless of your personal view today’s economy is fundamentally different from pre-1973, and I would argue not comparable.

Historical Performance during High Inflation Periods

So the first thing we want to do in our investigation is to look at historical inflation trends in the US from 1973 to today.

For the purposes of this study, I will define a “High Inflation Period,” or HIP, as any year in which inflation is above 5%, and from the above chart, we can identify 3 periods in which inflation spikes above this threshold: 1973-1976, 1977-1983, and 1990.

During these periods, let’s pretend that our unlucky retiree handed in their notice at the start of these 3 HIPs, and let’s model what happens for a 30-year retirement.

1973-2003

First, let’s look at 1973 to 2003. In this scenario, our retiree starts right after the gold standard ends, and one year before the Watergate scandal. So, plenty of political turmoil and uncertainty is on deck for our unfortunate investor.

We start our retiree with a $1,000,000 portfolio and have them begin withdrawing $40,000. We make sure that our retiree increases their spending by each year’s inflation number so that it keeps their buying power constant. And we set our retiree up with a 60/40 portfolio.

By plugging all these inputs into PortfolioVisualizer’s portfolio backtest tool, we get the following.

As you can see, we do have an extended period where the portfolio is just barely able to keep up with withdrawals. Almost immediately, our retiree’s portfolio dips below its initial starting value and doesn’t get back there until 1982, so we can see that a “lost decade” does happen due to inflation and stock market weakness. But, eventually, the compounding effect of time takes over and the portfolio romps higher, eventually ending their 30-year retirement period at about $2,000,000.

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1977-2007

Our next HIP is 1977 to 2007. Being only a few years off, you’d think that the chart would look more or less the same as the last one. You would be wrong.

Source: PortfolioVisualizer.com: 1977-2007

Yowza. What a difference 4 years make.

Instead of the portfolio ending up at “only” $2M and a paltry 2.56% Compound Annual Growth Rate (or CAGR) as in the 1973-2003 analysis, the 1977-2007 retirement ends up at nearly $10M, with a CAGR of 7.63%!

Why is this?

Despite inflation actually being worse at the start of 1977 versus 1973, 1977 corresponds to a period of economic expansion from 1977 to about 1980, while 1973 started during a period of economic contraction. As we know, sequence of return risk is highest when you retire right as stock markets are tanking because it forces you to sell into a downward market, so by retiring during a booming stock market our 1977 retiree ends up doing way better than the 1973 retiree, despite going into a period of extremely high inflation that eventually peaks at a nosebleed 13.55% in 1980.

1990-2020

Finally, let’s look at our last HIP.

The 1990s is probably the period most similar to today, because while inflation was relatively high, unemployment was not. In the 1990s, then-federal chairman Alan Greenspan was able to engineer a soft landing by raising interest rates gradually without causing a recession, and we can see that in the final results of a retiree starting their withdrawals during this period. Our retiree ended this period with a final balance of about $7.5M, with a CAGR of 6.68%.

Analysis

So what happened here? Interestingly, none of the FIRE simulations starting in years of high inflation since 1973 actually failed. We have two major reasons here to thank for this.

Equities are a Natural Inflation Hedge

Every single FIRE blog out there advocates for holding a portfolio that contains mostly equities. The main reason for this is that people who retire early tend to have very long investment horizons, typically 30+ years. And with investment periods that long, nothing beats equities in terms of raw performance.

An added bonus of this is that equities naturally hedge against inflation.

Think about it. Every time you fill up your tank or buy groceries and curse at how much money you’re now paying versus just a few months ago, the company you’re buying from is making more money. Sure, stock markets are behaving crazy right now, but long term, a well-managed company will be able to translate those higher incomes into higher profits, as we’re now seeing with energy companies who are able to benefit from these crazy oil prices caused by the war in Ukraine.

This effect does not translate to other asset classes. In fact, if our imaginary retiree had reacted to the increased stock market volatility by running into bonds, according to the same simulation tool that generated those pretty graphs, their retirement would have failed big time.

The lesson is clear. If you don’t want to get creamed by inflation, keep at least 60% of your portfolio invested in equities.

We’re Getting Better at Fighting Inflation

The other reason has less to do with math and more to do with human behavior. We, as a species, are not the best at anticipating and avoiding bad things before they happen, but we are pretty good at learning once that bad thing smacks us in the face.

Every time governments deal with a period of high inflation, they tend to try a bunch of random, well-meaning ideas. Some ideas work great. Other ideas fail spectacularly.

Over time, as a species, we gain a kind of institutional knowledge. We learn to build on ideas that work while discarding ideas that don’t. Dramatically increase interest rates like in the 1980s? Good idea. Raise tariffs and choke off international trade? Bad idea. Start a war with a random country? Extremely bad idea.

Over time, governments all around the world have figured out that if you encounter high inflation, you increase interest rates and reduce the money supply. That’s what we’re currently doing in the US and Canada, and despite the wailing and whining of over-indebted homeowners, the government is not going to stop because they know that’s how you eventually defeat inflation.

The elimination of the gold standard was actually a big part of this evolution, as it freed up the US government from pinning their money supply to a physical asset and instead allowed them to adjust it as economic conditions saw fit. That’s why the last recession caused by the pandemic was the shortest one on record.

The 4% rule that the FIRE community bases its entire existence on states that if you spend no more than 4% of your initial retirement portfolio, adjusted to inflation, you will not run out of money in a 30-year retirement period 95% of the time.

That “95% of the time” number comes from analyzing historical performance for 30-year periods using stock and bond market performance dating back to the beginning of the 1900s. And according to the personal blog of the Trinity Study’s author, Wade Pfau himself, the 5% of the time his simulations failed all occurred before 1973.

That’s right. Since the gold standard was abolished, and central banks became free to set their interest rates at whatever level they thought best to combat inflation, the principles of FIRE have NEVER failed.

The Last Word

To be honest, when FIRECracker challenged me to write a “nerdy dorkmeister” article about inflation at the beginning of this week, I didn’t know where my research would lead me. Maybe I would discover that inflation was toxic to early retirees and I’d have to abandon this article and start over.

But as it turns out, I discovered the opposite.

The principles of FIRE have never been stronger, or more relevant.

Don’t mindlessly spend all your money. Because then you are at the mercy of your employer.

Don’t go into debt to buy a house. Because that puts you at the mercy of central banks.

But if you invest your money into equities, shares of companies that make money no matter what happens, then according to the data and the math, you’re going to be just fine.

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