“Inflation may have become the oldest form of government finance. It may also have been the oldest form of political confidence game used by leaders to exact tribute from constituents, older even than taxes, and inflation has kept those honored places in human affairs to this day…For at least four thousand years of recorded history, man has known inflation.”
—Jens O. Parsson, Dying of Money
Benjamin Franklin once said that the only certainties in life are death and taxes. To that I would add a third certainty, which is inflation. For as long as I have lived, I have had to deal with inflation as an ordinary part of life. Occasionally, there are brief episodes of deflation, but these are typically confined to a severe financial crisis or economic crash such as we saw during the Great Depression or following the Great Financial Crisis of 2007-2008. Outside these rare occasions, the economic norm is inflation: low, moderate, or high as it is today.
Politicians are apt to obfuscate inflation, deflecting blame to some event like an oil crisis, pandemic, a war, “acts of god”, or greedy businesses or labor unions wanting to raise wages.
The great majority of people today, including even the great majority of professional economists, define inflation in terms of its leading symptoms: rising prices. However, defining inflation as rising prices says absolutely nothing about any specific cause of inflation. It implies, therefore, that inflation is simply the result of anything that raises prices. Believing that rising prices causes inflation leads one to believe it is causeless, or due to something caused by the evil of private individuals, especially greedy businessmen. A good example is today where the administration blames greedy oil companies for rising gasoline prices rather than their own policies which have restricted supply.
The Austrian economists gave us the true cause of inflation, which is the supply of money. The quantity theory of money connects the increase in the quantity of money to the rise in prices by way of establishing a connection to more demand. A growing quantity of money raises the demand for consumers goods through the new and additional money being spent and re-spent, which raises the price of goods.
This can be demonstrated by the charts below of the US national debt, the Fed’s balance sheet, and M-2 money supply over the last three years of the pandemic. The government used helicopter drops of money through stimulus checks while restricting the supply of goods through lockdowns of the economy. What we got was a classic case of inflation: “Too much money chasing too few goods.” Is it any wonder that we are experiencing the highest levels of inflation in over four decades?
As the three graphs below illustrate, from January of 2019 to its peak in March of 2022, M-2 money supply increased by over 51%. During that same period the Fed’s balance sheet expanded from $4.058 trillion in 2019 to its peak of $8.946 trillion in May of last year, an increase of over 120% while the national debt grew by $9.456 trillion, an increase of 43%. The result is what you see today: rising prices everywhere from the cost of goods, services, to the price of labor.
My reason for focusing on inflation is its impact on retirees and retirement planning. Since its inception, my company has specialized in retirement planning, helping people save for retirement and navigate their retirement years. After an extensive amount of reading and research, including 8 new designations these last three years, I am convinced the financial industry has gotten retirement planning all wrong. Specifically, the rate of withdrawal on assets once you retire, and the asset allocation of a retirement portfolio. There are two rules widely used in retirement planning. The age rule on asset allocation and the 4% rule on the spending down of assets.
Let’s begin with the age rule which defines how much of a person’s portfolio should be allocated between stocks and bonds. You take the number 100 minus your current age and that defines what you should allocate to stocks. For example, if you are age 65 when you retire, subtracting 65 from 100 equals 35%, the number you should invest in equities with the remaining 65% is invested in bonds and cash. At age 80 your equity portfolio would decline to 20%.
The next rule is on the withdrawal or spend down of your assets, which is 4% per year. Assuming a $1,000,000 portfolio, you would withdraw $40,000 a year which would last 25 years of your retirement. Both rules have major flaws with their reasoning, which I will explain.
Let’s begin with the age rule which defines the amount invested in equities as you age. The older you get the less you should have invested in stocks. Unfortunately, this makes much less sense when you take inflation into account, especially periods of high inflation. Two recent articles in Barron’s illustrate the fallacy of this rule:
- High Healthcare Costs Are a Challenge, Even for Healthy Seniors
- Rethinking Retirement Savings in Light of Longer Life Spans
People are living longer and the healthier you are, the longer you will live and the more you will end up spending on healthcare as you age. Retirees are now living into their late 80s and early 90s. As one of the Barron’s articles points out, you could live to 100. The trick is not running out of money. Equities are the engine your portfolio needs in the long run. How else will you be able to deal with rising healthcare inflation which runs 6-8% a year, especially if inflation continues to come in at higher-than-average levels? To us, it now makes less sense to apply this age-rule formula to reduce equity holdings as you age when your cost of living rises each year. The example below illustrates the inflation dilemma that most retirees will face throughout their retirement years.
Whatever the inflation rate that unfolds during the next 10-30 years, your annual expenses will be going up each year. In such an environment, a bond and cash portfolio will not see you through retirement unless you are incredibly wealthy. Bonds don’t increase their yield over the life of the bond. If you bought a Treasury bond ten years ago, the yield was 2% at the time the bond was issued. Ten years later, that bond still pays you the same 2% at the time it matures. However, that bond will not buy you the same good and services that it would have bought ten years ago when it was issued.
As shown in the table above, even with moderate inflation of 3%, which is close to what we have experienced on average over the last ten years, you will need 80 - 150% more income to live 20 - 30 years from now. Below is the purchasing power of a $100,000 bond under different inflation rates.
The two tables above illustrate why I feel strongly that using your age to determine your asset allocation does not make sense in an era of inflation and at a time when we are living longer. Imagine what will happen to your living expenses under various inflation rates and what happens to the purchasing power of your bonds. In 20 years, your cost of living will rise to $135,000 from $75,000 and the purchasing power of your bond will decline to $54,000 under a 3% inflation rate. The numbers get even more dismal under higher inflation rates.
It doesn’t make sense to allocate more to bonds as you age. In fact, I am in the Warren Buffett camp that believes bonds are a poor long-term investment:
“It is a terrible mistake for investors with long-term horizons—among them, pension funds, college endowments and savings-minded individuals—to measure their investment 'risk' by their portfolio's ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk." (See Warren Buffett: Why Bonds Are a Terrible Investment)
The first hurdle you must overcome during retirement is inflation. The nature of the current economic environment leads to one inevitable conclusion: you cannot hide in fixed-income investments. The so-called “safe investments” aren’t really safe at all when you realize that stagnant capital will not keep you ahead of inflation. At the risk of sounding like a heretic, let me be blunt: bonds are a bad investment. Bonds have more of the nature of savings, more than they do an investment.
After that seemingly heretical statement, let me move on to another fallacy which is the 4% drawdown rule. This rule, which would entail withdrawing 4% a year from your portfolio, only works in a bull market. It can become deleterious to your financial health during a bear market as we are now undergoing. The second problem with the 4% rule is you must withdraw more each year to keep up with inflation. Let’s look at a recent example from last year where the S&P 500 lost over 20%, as did bonds, while the Nasdaq lost 33%.
Here is an example of what happened if you withdrew 4% of your portfolio at a time markets were plunging. I have used the S&P 500 ETF (SPY) during 2022 for illustration purposes and a $1,000,000 portfolio using a 4% withdrawal rate, which would be $3,333 per month. The share value January 1st was $477.71 at the beginning of the year for a total of 2,093 shares.
At the end of the year, December 31st, share prices closed at $382.43, reducing the portfolio to a value of $763,305.22. A loss of over $236,695 after a decline in the price of shares and withdrawals. So, starting out this year, you have almost a quarter of million less in asset value to work with and the withdrawal rate needs to increase to account for inflation. The inflation rate for 2022 was 6.5%, so to keep the same purchasing power you would need to increase the monthly withdrawal rate to $3,550 per month to keep the same level of purchasing power. Since bear markets can last as long as 2 years, just imagine what could happen to a withdrawal rate that takes place in another year of declining stock prices. The bear market of 2000 lasted for two and half years with a loss at the bottom of nearly 50%. The bear market of 2007 - 2009 lasted 17 months with a loss in value of around 56%.
Therefore, in my opinion, it is why the 4% rule only works in a long-extended bull market characterized by rising stock prices each year. An extended bear market can devastate a portfolio, and, more importantly, imperil your retirement if relying on withdrawals during a declining bear market in equities.
This is the main reason I believe the financial industry has gotten retirement planning all wrong as the age and 4% rule does not account for inflation or bear markets. For these reasons, and as my 43 years of experience have taught me, this approach does not work long-term when planning for retirement. A better solution, I believe, is to own high quality blue-chip, dividend paying stocks. In my opinion, they are the best inflation hedge that I know of that can help you keep pace with inflation and build your wealth. The best example I know of is Warren Buffett’s Berkshire Hathaway, who unlike most insurance companies, invests in stocks, either buying dividend paying stocks with strong cash flows or buying the companies outright.
I want to illustrate this point in the table below which features three consumer product companies, one drug company, and one integrated oil company, some of which Warren Buffett currently holds or has owned in the past.
The examples above assume a $100,000 investment in each stock. I show the value of the stock after 10 years and the yield on original capital (YOOC) made ten years ago, and the annual growth rate of the shares.
My favorite example is AbbVie and Altria. In both cases, the dividend yield ten years later after original investment has grown to 12.9% on original capital on AbbVie to 17.6% on Altria. Both share prices grew by annual growth rates of 16% for AbbVie and 4% for Altria. As shown above, had you invested $100,000 in each stock, your income nearly doubled in each case in addition to the growth of your original principal, easily keeping you ahead of inflation in both income and in principal.
One reason I use individual stocks is that I have greater certainty when it comes to income. Many investors mistakenly believe that in a market downturn as stock prices fall so does their income. That may be the case with a mutual fund or an ETF. That is not the case when it comes to the dividend aristocrats we own. The best example is the Great Financial Crisis of 2007-2009, a period where the S&P 500 lost around 56% of its value. The stocks listed below all went down with the market by half as much as the general market. The reason is those dividend yields acted as a floor under the stock. Had you done nothing during the financial crisis your income would have gone up every year as illustrated below.
So had you done nothing and held on, your income went up even though the stock price fell as the underlying business did just fine. It is not just the fact that the dividends were raised every year but many of these companies such as Coke, PG, and JNJ have raised dividends every year for 50-60 years.
It is something I have learned over the years from studying Warren Buffett and his mentor Benjamin Graham. I remember reading about Buffett’s investment in Coca Cola in the late 1980s. Buffett originally bought 23 million shares of Coke between 1988-1989. He then quadrupled his position to 100 million shares by 1994 for a total investment of $1.3 billion. He has not sold a share and thanks to stock splits he now owns 400 million shares making his original investment of $1.3 billion worth $24 billion today for a return of 2,000 percent. Thanks to stock splits and share buybacks, Buffett now owns 9.25% of all Coke shares. As Buffett is fond of saying, he looks at his stocks as bonds that pay increasing interest rates over time, making him one of the wealthiest investors on the planet.
In my financial career, I've come to realize that many of the tenets we are taught and that are propagated by the financial industry may appear feasible in academic papers but tend to fail in practice. For example, the age-based asset allocation rule proves ineffective in dealing with inflation, and the 4% withdrawal rule is not practical during prolonged bear markets. Personally, I am convinced that we will be confronting persistent high inflation rates. This is one thing that I believe is certain and must be addressed, along with death and taxes.
I've also learned that making accurate predictions about the performance of the financial markets at the end of the year is a challenging task. Any such forecast I make would be nothing more than an estimate. However, I am much more confident in predicting where I think the dividends on the stocks I own will likely be at the end of the year. That is as close as I can get to certainty when it comes to the financial markets in knowing what your dividends will be at the end of each year and the year that follows. Additionally, it's the most effective means I know of for helping investors to keep pace with inflation.
It is the one reason why I started my equity income account 4 years ago investing in well managed dividend-paying companies that meet my "10% dividend rule" consisting of dividend yield and dividend growth (for example, dividend yield equals 6% with an average dividend growth rate equal to 4% each year). Since inception, we have averaged 3.5 - 4% on yield with annual dividend growth of 10% or more each year. Last year was our best year ever with dividend increases of 11.56%. It is why I believe blue-chip dividend stocks are the best inflation hedge that I know of.
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