Expanded Allocator Insights D
This time, I examined inflation. It doesn’t cause nearly so much damage as I had expected.
Conditions
I took the optimal condition from Taken At Face Value. Here is a summary:
Investment A: 3.5% initial yield with an 8% per year nominal growth rate. Investment B: 6.1% initial yield with a 2% per year nominal growth rate. TIPS: 2% real interest rate. Inflation: 3% per year. Initial allocation: 15% investment A, 85% investment B and 0% TIPS. Withdrawal rate: 5.590% plus inflation.
I determined the effect of increasing and decreasing inflation by 1%. Here are my findings:
Investment A: 3.5% initial yield with an 8% per year nominal growth rate. Investment B: 6.1% initial yield with a 2% per year nominal growth rate. TIPS: 2% real interest rate. Inflation: 4% per year. Initial allocation: 15% investment A, 85% investment B and 0% TIPS. Withdrawal rate: 4.910% plus inflation.
Investment A: 3.5% initial yield with an 8% per year nominal growth rate. Investment B: 6.1% initial yield with a 2% per year nominal growth rate. TIPS: 2% real interest rate. Inflation: 2% per year. Initial allocation: 15% investment A, 85% investment B and 0% TIPS. Withdrawal rate: 5.710% plus inflation, which is the first year’s income.
Interpretation
Keep in mind that all withdrawal rates include adjustments that match inflation.
Inflation causes less than a 1 for 1 reduction in real buying power. A 1% increase of inflation from 3% to 4% reduces the continuing withdrawal rate from 5.590% plus inflation to 4.910% plus inflation, a reduction of 0.680%.
Similarly, a 1% decrease in inflation from 3% to 2% increases the continuing withdrawal rate from 5.590% to 5.710%. The amount of income that is available during the first year limits the withdrawal rate. The income stream rises continually. Shifting entirely to the higher yielding Investment B portfolio would increase the withdrawal rate to 6.1% (plus inflation) since it grows at 2% per year.
Have fun.
John Walter Russell April 25, 2007
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