Albert Einstein once said “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.” Unfortunately, regardless of our financial understanding, we are all payers of compound interest in the form of inflation. In the US, from 1913 to 2015, the 10-year inflation averages have ranged anywhere from 9.80% to -2.08% while the average over the entire period has been 3.18%. Someone who retires at 65 might need to make their money last for 20 years, but someone who retires at 55 might need to make their money last 30 years. If inflation averaged 3% for the rest of our lives, a $4,000 per month spend rate would increase to $7,225 after 20 years. After 30 years, it would increase to $9,709.
Someone who managed to achieve financial independence would find they would have to diminish their lifestyle immediately. After 25 years, they would find their lifestyle cut in half. Thus, the key to income replacement is to find a way to make it increase to match inflation. The only ways to do this are to save more or to accept more uncertainty (risk).
Immediate annuities allow one to make a one time purchase that guarantees a steady monthly income. The downside is that payment is fixed and will never increase. A variation on this is the inflation-adjusted annuity. This type of annuity increases the monthly payout every year by the rate of inflation. In fact, this is pretty much how Social Security works. However, the devil is in the details. There are many ways to measure inflation and these annuities typically pick a method that results in a lower rate of inflation. The big downside to inflation adjusted annuities is that they pay out much less than regular annuities. In general, you can expect a payout of 2/3rds that of a regular annuity. So, if you could buy an immediate annuity that would pay you $600 a month, you should expect an inflation-adjusted annuity to start your payments at only $400 a month. So, in order to get an inflation-adjusted annuity that would start at $600 a month, you would have to pay 50% more.
A very common rule of thumb is to put your money into an S&P 500 index fund and then withdraw 4% of it every year, Between 1928 to 2016, the average rate of return of the S&P 500 index has been around 10%, which is almost 7% more than inflation. So, one can withdraw 4% and still expect that amount to grow over the years. Unfortunately, stock market returns come with quite a bit of uncertainty. In the 88 years spanning 1928 through 2015, the S&P 500 has gone up in 64 of those years while falling in 24 of those years. The best year, 1954, saw a gain of 52.56%, but the worst year, 1931, saw a loss of -43.84%. So, if you are invested in the stock market for any length of time, you will almost certainly have a down year. So, how do you ride out the down years, and can you reduce the amount of losses during a down year?