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