DISTRIBUTION RATE VS INFLATION RATE: A DISTRIBUTIVE TALE

02 Sep DISTRIBUTION RATE VS INFLATION RATE: A DISTRIBUTIVE TALE

This tale examines the relationship between the inflation rate and the distribution rate.  It is not meant to give you a complete understanding about what other factors should be taken into consideration when planning for the “Distribution” or “In-Retirement” phase of your life.  It is just intended on teaching the relationship between these two factors.  These tales are a building block to knowledge and so the concepts have to be simple, clear and concise.  It will also provide some implications on portfolio construction once you recognize that the rate you withdraw money from your portfolio has a far more dramatic effect than the inflation rate.  This is not a well understood fact so you need to learn it.

MINIMUM PRESERVE PURCHASING POWER

As we learned in An Inflationary Tale and A Purchasing Power Tale, the objective of investing is to do so at a minimum preserve purchasing power.  If you examine the 4 possible states that a portfolio can inhabit what you learn is that portfolios are either in a state where people are adding to them, taking money from them, doing neither or doing both.  So a simple formula one might develop to capture all 4 possible states and how I classify portfolios that want to meet the minimum objective of investing would be the following;

The rate of return required to preserve purchasing power must exceed the combined effect of the inflation rate and the distribution rate.

The above seems very complex but it’s actually very simple if you allow the distribution rate to be positive, negative or zero.  For practical purposes it takes the 4 possible states and reduces them to 2.  This translates to you are either adding money or taking money from your portfolio.  If you are adding money to your portfolio then the distribution rate is negative and your objective is to exceed the inflation rate.  Some people call this the “Accumulation” phase of a person’s life.  If you are taking money from your portfolio then the distribution rate is positive and your objective is to exceed the inflation rate plus the distribution rate.  Some people call this the “Distribution” phase of a person’s life.  What’s certain is that portfolios that are distributing cash have a higher hurdle to exceed in order to meet their investment objectives than those that are accumulating since not only do they have to exceed the inflation rate, they have to exceed the distribution rate as well.

DISTRIBUTION RATE VS INFLATION RATE

This tale examines the relationship between the inflation rate and the distribution rate for portfolios that are in the “Distribution” phase and why it’s called A Distributive Tale.  Because portfolios in this phase have a higher hurdle in order to meet their minimum investment objective some people turn to a different objective since they acknowledge they can’t exceed the higher hurdle rate.  When they do they instead analyze strategies that are geared to generating income for life without dying broke.  This tale focuses on the relationship between the inflation rate and the distribution rate for portfolios that change their objective.  It is also instructive towards understanding the relationship between the inflation rate and the distribution rate for portfolios that don’t have to change their objective because they can exceed the higher hurdle rate.  For these people it will teach you to focus or understand exactly where the risk is in your portfolio.  The way I think of it is to separate Inflation Risk from Distribution Risk.  The lower the Distribution Risk, the less money you have to take out of your portfolio, the more you can focus on creating portfolios that mitigate Inflation Risk.   I hope this tale changes the way you look at how you manage money

Let’s develop a hypothetical framework.  Let’s assume a person has a set amount of money when and they want to make periodic and consistent distributions that match the inflation rate and they keep their money under their mattress or in other words make 0% on their money.  The following table will show you how long in years the money will last.  It details what happens under various Inflation Rates vs. Distribution Rates scenarios if you don’t invest your money.  I like it because it does not confuse or cloud the issue by introducing rates of return into the equation.

How Many Years Will Your Money Last under Different Inflation and Distribution Rates if You Keep Money under Your Mattress?

How should we read this table?  If we look at a 4% distribution rate and a 3% inflation rate we see that a person’s money invested at 0% runs out in 18 years.  The assumption I used was that if you start at time 0 and put for example $1,000 under your mattress then at the end of the year you would take out $40 which is your 4% distribution rate.  At the end of the second year you would take out $41.20 which is your distribution rate plus the inflation rate of 3%.  If you do this every year you run out of money in year 18.

PORTFOLIOS IN THE DISTRIBUTION PHASE

Now that we know how to read this table, can we gain any insights?  The obvious insight is that for portfolios in the “Distribution” phase of life, the distribution rate is more important than the inflation rate.  This is an obvious point but one most people don’t understand.  I actually know some advisors that think the inflation rate is equally or more important than the distribution rate.  If you know any that do—please find another advisor to guide you through this phase of your life.  For example, a quick glance shows you that a 5% distribution rate coupled with a 2% inflationary rate lasts 16 years while the exact opposite which is a 2% distribution rate coupled with a 5% inflation rate will last 25 years.  So when analyzing portfolios that are taking money out make sure you recognize the importance of both factors.  Nevertheless, distribution is more important than inflation when making your money last.  As logical proof in case you don’t believe me, let’s go to an extreme or what I call a mind exercise.  Let’s set the distribution rate at 0% and the inflation rate at 100%.  In this case you never run out of money because guess what—you are obviously distributing zero.  You can’t run out of money.  However, if you set the inflation rate at 0% then at any positive number for distribution you eventually run out of money.

DISTRIBUTION RATE VS INFLATION RATE: THE NUMBERS GET MESSY

So why is it that people and advisor get so mixed up about this and what are the implications when it comes to portfolio management?  The answer as to why they get mixed up is because there are a number of combinations where the numbers are so close that it doesn’t matter for practical purposes.  For example a 3% inflation rate with a 4% distribution rate has you running out of money in 18 years while a 4% inflation rate with a 3% distribution rate has you running out of money in 21 years.  People and advisors have a tendency to approximate and since historical inflation has been around the 3-4% range and most portfolios in distribution are around the 3-4% range as well there has been a tendency to clump the two together.  However, the clumping of the two can be dangerous because as we’ve learned in many of these tales–averages are deceiving.  The implications to portfolio management are subtle but very important.  There is a difference between what I call Inflation Risk and Distribution Risk.  The less Distribution Risk you have the more you should protect against Inflation Risk.  Once you understand this it is easy to see why portfolios that are not distributing income or said differently, portfolios or people in the wealth accumulation phase of their life, need only worry about Inflation Risk.

I like to use the following table when talking to people about how to manage their money in retirement.  It is far more powerful than the table above but has the same meaning.  It sends the message home about the relationship between the inflation rate and the distribution rate.

At What Age Will a 65 Year Old Run Out of Money under Different Inflation and Distribution Rates if They Keep Their Money under Their Mattress?

The above is a scary table to most people.  What it says for example is that if you are 65  and you want to distribute 5% of your money every year and keep up with inflation of let’s say 2% then you will run out of money at age 81.  To drive home the point if we look at the opposite scenarios where you instead distribute 2% and experience 5% inflation your money lasts until age 90 or an additional 9 years.  You’ve read it here so remember–the distribution rate is more important than the inflation rate for portfolios in the “Distribution” phase of life.

Once you understand this effect it is important that you read A Required Return Tale immediately after.  It is another boring math oriented tale but crucial.  In that tale I will provide the reader with a set of tables that show the effect of rate of return in conjunction with the inflation rate and the distribution rate.  In this tale I simply assumed the rate of return was 0% per year or that your money was under your mattress.  However, that is not the case for most investors since they earn a positive return.

Carlos Sera
carlos@seracapital.com

Carlos Sera Founder of Sera Capital Management, LLC Co-Founder of Chicago Wealth Management, Inc. Registered Investment Advisor Speaker on Financial/Investment Planning Fluent in Spanish – First Generation Cuban/American Author of Financial Tales Blog Education Johns Hopkins University – BA – Natural Science – 1980 University of Rochester – MBA – Finance and Applied Economics – Honors – 1982 Find me on:  LinkedIn | Twitter

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