Inflation: Transitory or Here to Stay?

From leading indicators to business surveys to initial unemployment claims, the economic message is clear: The 2020 COVID-19 recession is over! Although the NBER (National Bureau of Economic Research) has yet to make their official announcement, my bet is that the recession ending point is backdated all the way to last autumn, or even earlier. That's how economics often works… with perfect 20/20 hindsight.

As the economy’s emergence from pandemic restrictions exceeds widespread forecasts and expectations, so do underlying pressures in other areas vital to the stock market’s outlook. And with the combination of a potential valuation bubble on Wall Street and corresponding housing bubble on Main Street, investor sensitivity to interest rates has never been higher.

In April 2021, the Consumer Price Index for All Urban Consumers (CPI-U) rose 0.8%, the largest one-month increase since August 2012. Over the previous 12 months, the increase was 4.2%, the highest year-over-year inflation rate since September 2008 (4.9% over prior 12 months). By contrast, inflation in 2020 was just 1.4%. ⁽¹⁾

The annual increase in CPI-U — often called headline inflation — was due in part to the fact that the index dropped in March 2020, the beginning of the U.S. economic shutdown in the face of the COVID-19 pandemic. Thus, the current 12-month comparison is to an unusual low point in prices. The index dropped even further in April 2020, and this "base effect" will continue to skew annual data through June. ⁽²⁾

The monthly April increase, which followed a substantial 0.6% increase in March, is more indicative of the current situation. Economists expect inflation numbers to rise for some time. The question is whether they represent a temporary anomaly or the beginning of a more worrisome inflationary trend.

Measuring Prices

In considering the prospects for inflation, it's important to understand some of the measures that economists use.

CPI-U measures the price of a fixed market basket of goods and services. As such, it is a good measure of prices consumers pay if they buy the same items over time, but it does not reflect changes in consumer behavior and can be unduly influenced by extreme increases in specific categories.

In setting economic policy, the Federal Reserve prefers a different inflation measure called the Personal Consumption Expenditures (PCE) Price Index, which is even broader than the CPI and adjusts for changes in consumer behavior — i.e. when consumers shift to purchase a different item because the preferred item is too expensive. More specifically, the Fed looks at core PCE, which rose 0.7% in April and 3.6% for the previous 12 months, slightly lower than core CPI but much higher than the Fed's target of 2% for healthy economic growth. ⁽³⁾

A Hot Economy

Based on the core numbers, inflation is not yet running high, but there are clear inflationary pressures on the U.S. economy. Loose monetary policies by the central bank and trillions of dollars in government stimulus could create excess money supply as the economy reopens. Pent-up consumer demand for goods and services is likely to rise quickly, fueled by stimulus payments and healthy savings accounts built by those who worked through the pandemic with little opportunity to spend their earnings. Businesses that shut down or cut back when the economy was closed may not be able to ramp up quickly enough to meet demand. Supply-chain disruptions and higher costs for raw materials, transportation, and labor have already led some businesses to raise prices. ⁽⁴⁾

According to the April Wall Street Journal Economic Forecasting Survey, gross domestic product (GDP) is expected to increase at an annualized rate of 8.4% in the second quarter of 2021 and by 6.4% for the year — a torrid annual growth rate that would be the highest since 1984. As with the base effect for inflation, it's important to keep in mind that this follows a 3.5% GDP decline in 2020. Even so, the expectation is for a hot economy through the end of the year, followed by solid 3.2% growth in 2022 before slowing down to 2.4% in 2023. ⁽⁵⁾⁽⁶⁾

Three Scenarios

As investors have become increasingly concerned about inflation, the Federal Reserve has given countless reassurances that current pricing pressures will be “transitory” and short-lived. Yet mounting evidence has seemingly turned this debate into the Fed versus the World.

Will the economy get too hot to handle? Though all economists expect inflation numbers to rise in the near term, there are three different views on the potential long-term effects.

The most sanguine perspective, held by many economic policymakers including Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen, is that the impact will be short-lived and due primarily to the base effect with little or no long-term consequences. ⁽⁷⁾ Inflation has been abnormally low since the Great Recession, consistently lagging the Fed's 2% target. In August 2020, the Federal Open Market Committee (FOMC) announced that it would allow inflation to run moderately above 2% for some time in order to create a 2% average over the longer term. Given this policy, the FOMC is unlikely to raise interest rates unless core PCE inflation runs well above 2% for an extended period. ⁽⁸⁾ The mid-March FOMC projection sees core PCE inflation at just 2.2% by the end of 2021, and the benchmark federal funds rate remaining at 0.0% to 0.25% through the end of 2023. ⁽⁹⁾

The second view believes that inflation may last longer, with potentially wider consequences, but that any effects will be temporary and reversible.

The third perspective is that inflation could become a more extended problem that may be difficult to control. Both camps project that the base effects will be amplified by "demand-pull" inflation, where demand exceeds supply and pushes prices upward. The more extreme view believes this might lead to a "cost-push" effect and inflationary feedback loop where businesses, faced with less competition and higher costs, would raise prices preemptively, and workers would demand higher wages in response. ⁽¹⁰⁾

Is Current Inflation "Transitory?

Dual surveys from the Institute for Supply Management (ISM) are ringing alarm bells, as the ISM Manufacturing Prices Paid Index has surged to one of its highest readings on record, led by widespread commodity price increases. As stated by one respondent to the ISM survey, “In 35 years of purchasing, I’ve never seen anything like these extended lead times and rising prices – from colors, film, corrugate to resins, they’re all up.” Likewise, even in the Service Sector the Prices Paid Index shot higher and is nearing a 25-year high.

Low inventories among companies that produce goods will undoubtedly keep price pressures high as companies scramble to replenish their depleted inventory and meet the unexpectedly high demand.” And prices have, indeed, continued to rise, while restocking efforts have been unable to prevent customer inventories from falling to a record low.

Central to the Fed’s “transitory inflation” argument is the belief that supply/demand pressures will quickly subside as inventories rebound. My concern is that broader evidence suggests inflation could be far stickier than the Fed expects.

From groceries to lumber to cars and even chickens, inflation pressures are being felt by consumers and businesses. The widespread nature of today’s inflation is one of the factors that suggest pricing pressures may be more deep-rooted than the Fed believes.

Perhaps most importantly, business owners are also facing higher wage costs as qualified labor is becoming an increasingly rare commodity. The National Federation of Independent Business (NFIB) reports that a record 44% of small businesses have unfilled positions, and over half of those with job openings reported that there were few or no qualified applicants.

Historically, wage inflation can be notoriously sticky, and the disparity between the NFIB Job Openings and reported Wage Inflation is a gap that will almost certainly be closed in the year ahead. This casts further doubt on the Fed’s narrative that inflation will surely be “transitory.” And unfortunately for the Fed, wage inflation–once ingrained–can typically only be reversed by a recession.

As businesses are facing higher input expenses, they are already making plans to pass these costs on to their customers. The National Federation of Small Business' survey of small businesses shows that plans to raise selling prices have reached the second highest level since 1981 – a time when inflation was running near 10%.

Maintaining Perspective

Although it's too early to tell whether current inflation numbers will lead to a longer-term shift, you can expect higher prices for some items as the economy reopens. Consumers don't like higher prices, but it's important to keep these increases in perspective. Gasoline, jet fuel, and other petroleum prices are rising after being deeply depressed during the pandemic. Airline ticket prices are increasing but remain below their pre-pandemic level. Used cars and trucks are more expensive than before the pandemic, but clothing is still cheaper. ⁽¹¹⁾ Food is up 3.5% over the last 12 months, a significant increase but not extreme for prices that tend to be volatile. ⁽¹²⁾

Anyone who has tried to buy or build a home in the past six months is aware of the rising stresses in the housing market. Home prices are soaring, not only here in the U.S. but on a global basis as well.

History has shown that it will be difficult, if not impossible, for the Federal Reserve to dampen or halt the imminent impact of the red-hot labor and housing market on the economy. Any cost surprises will undoubtedly be to the upside in the months and year ahead, and that does not bode well for inflation news OR for the Fed’s reassurance of “transitory” inflation.

For now, it may be helpful to remember that "headline inflation" does not always represent the larger economy. And with interest rates near zero, the Federal Reserve has plenty of room to make any necessary adjustments to monetary policy.

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Projections are based on current conditions, are subject to change, and may not come to pass.

1, 12) U.S. Bureau of Labor Statistics, 2021

2, 4) The Wall Street Journal, April 13, 2021

3, 6) U.S. Bureau of Economic Analysis, 2021

5) The Wall Street Journal Economic Forecasting Survey, April 2021

7, 10) Bloomberg, March 29, 2021

8) The Wall Street Journal, April 14, 2021

9) Federal Reserve, 2021

11) The New York Times, April 13, 2021

Enhanced Child Tax Credit for 2021

The American Rescue Plan Act of 2021 (ARPA) ushered in several tax changes that we highlighted in this post last month. One of those tax changes involves the Enhanced Child Tax Credit.

If you have qualifying children under the age of 18, you may be able to claim a child tax credit (You may also be able to claim a partial credit for certain other dependents who are not qualifying children.) The American Rescue Plan Act of 2021 makes substantial and temporary improvements to the child tax credit for 2021, which may increase the amount you might receive.

Ages of qualifying children

The legislation makes 17-year-olds eligible as qualifying children in 2021. Thus, children age 17 and younger are eligible as qualifying children in 2021.

Increase in credit amount

For 2021, the child tax credit amount increases from $2,000 to $3,000 per qualifying child ($3,600 per qualifying child under age 6). The partial credit for other dependents who are not qualifying children remains at $500 per dependent.

Phaseout of credit

The combined child tax credit (the sum of your child tax credits and credits for other dependents) is subject to phaseout based on modified adjusted gross income (MAGI), which for most people, is your total income subject to taxes (this may differ from your taxable income shown on the tax return if you have certain adjustments). Special rules start phasing out the increased portion of the child tax credit in 2021 at much lower thresholds than under pre-existing rules. The credit, as reduced under the special rules for 2021, is then subject to phaseout under the pre-existing phaseout rules.

The following table summarizes the effect of the phaseouts on the child tax credit in 2021, based on MAGI.

Single/Married filing separately	Married filing jointly	Head of household	Combined credit
Up to $75,000	Up to $150,000	Up to $112,500	No reduction in credit
$75,001 to $200,000	$150,001 to $400,000	$112,501 to $200,000	Credit can be reduced to $2,000 per qualifying child, $500 per other dependent
More than $200,000	More than $400,000	More than $200,000	Credit can be reduced to $0

Enhanced Child Tax Credit is Refundable

The aggregate amount of nonrefundable credits allowed is limited to your tax liability. With refundable credits, a taxpayer may receive a tax refund at tax time even if they exceed their tax liability.

For most taxpayers, the child tax credit is fully refundable for 2021. To qualify for a full refund, the taxpayer (or either spouse for joint returns) must generally reside in the United States for more than half of the taxable year. Otherwise,  under the pre-existing rules, a partial refund of up to $1,400 per qualifying child may be available. The credit for other dependents is not refundable.

Advance payments

Eligible taxpayers may receive periodic advance payments for up to half of the refundable child tax credit during 2021, generally based on 2020 tax returns.  The U.S. Treasury will make the payments between July and December 2021. For example, monthly payments could be up to $250 per qualifying child ($300 per qualifying child under age 6). Due to correspondence backlogs and under-staffing at the IRS, it remains to be seen if they can make good on sending out those payments on a timely basis this year.

If you would like to review your current investment portfolio, discuss any other financial planning or tax matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Tax Deadline Extended Amid Tax Changes in American Rescue Plan

2020 Individual Income Tax Return Deadline Extended

The Treasury Department and the IRS have extended the federal income tax filing due date for individuals for the 2020 tax year from April 15 to May 17. Although this relief applies to any balance due with the return, this relief does not apply to 2021 estimated income tax payments that are due on April 15, 2021. These payments are oddly still due on April 15, 2021. The IRS will provide formal guidance in the coming days.

The federal tax filing deadline postponement to May 17, 2021 is of no help to self-employed people and others who don't receive a steady source of income because it only applies to individual federal income returns and tax (including tax on self-employment income) payments otherwise due April 15, 2021, not state tax payments or deposits or payments of any other type of federal tax. Given that the first quarterly 2021 estimated income payment due date is April 15, and knowing that it often is based on a prior year return, not extending that deadline as well is an empty gesture by the IRS for these folks. The American Institute of CPA's has appealed to the IRS to act swiftly to remedy this and extend the deadline for all returns and estimates until June 15, 2021. I concur with this appeal.

Taxpayers also will need to file income tax returns in 42 states plus the District of Columbia. State filing and payment deadlines vary and are not always the same as the federal filing deadline. Nonetheless, many states will conform with and follow the new IRS deadline. The IRS urges taxpayers to check with their state tax agencies for those details.

American Rescue Plan of 2021

On Thursday, March 11, 2021, the American Rescue Plan Act of 2021 (ARPA 2021) was signed into law. This is a $1.9 trillion emergency relief package that includes payments to individuals and funding for federal programs, vaccines and testing, state and local governments, and schools. It is intended to assist individuals and businesses during the ongoing coronavirus pandemic and accompanying economic crisis.  Major relief provisions are summarized here, including some tax provisions.

Recovery rebates (stimulus checks)

Many individuals will receive another direct payment from the federal government. Technically a 2021 refundable income tax credit, the rebate amount will be calculated based on 2019 tax returns filed (or on 2020 tax returns if filed and processed by the IRS at the time of determination) and sent automatically via check, direct deposit, or debit card to qualifying individuals. To qualify for a payment, individuals generally must have a Social Security number and must not qualify as the dependent of another individual.

The amount of the recovery rebate is $1,400 ($2,800 if married filing a joint return) plus $1,400 for each dependent. Recovery rebates start to phase out for those with an adjusted gross income (AGI) exceeding $75,000 ($150,000 if married filing a joint return, $112,500 for those filing as head of household). Recovery rebates are completely phased out for those with an AGI of $80,000 ($160,000 if married filing a joint return, $120,000 for those filing as head of household).

Unemployment provisions

The legislation extends unemployment benefit assistance:

• An additional $300 weekly benefit to those collecting unemployment benefits, through September 6, 2021
• An additional 29-week extension of federally funded unemployment benefits for individuals who exhaust their state unemployment benefits
• Targeted federal reimbursement of state unemployment compensation designed to eliminate state one-week delays in providing benefits (allowing individuals to receive a maximum 79 weeks of benefits)
• Unemployment benefits through September 6, 2021, for many who would not otherwise qualify, including independent contractors and part-time workers

For 2020, the legislation also makes the first $10,200 (per spouse for joint returns) of unemployment benefits nontaxable if the taxpayer's modified adjusted gross income is less than $150,000. If a 2020 tax return has already been filed, an amended return may be needed. The IRS urges patience on filing amended returns until they issue additional guidance.

Business relief

• The employee retention tax credit has been extended through December 31, 2021. It is available to employers that were significantly impacted by the crisis and is applied to offset Social Security payroll taxes. As in the previous extension, the credit is increased to 70% of qualified wages, up to a certain maximum per quarter.
• The employer tax credits for providing emergency sick and family leave have been extended through September 30, 2021.
• Eligible small businesses can receive targeted economic injury disaster loan advances from the Small Business Administration. The advances are not included in taxable income. Furthermore, no deduction or basis increase is denied, and no tax attribute is reduced by reason of the exclusion from income.
• Eligible restaurants can receive restaurant revitalization grants from the Small Business Administration. The grants are not included in taxable income. Furthermore, no deduction or basis increase is denied, and no tax attribute is reduced by reason of the exclusion from income.

Housing relief

• The legislation allocates additional funds to state and local governments to provide emergency rental and utility assistance through December 31, 2021.
• The legislation allocates funds to help homeowners with mortgage payments and utility bills.
• The legislation also allocates funds to help the homeless.

Health insurance relief

• For those who lost a job and qualify for health insurance under the federal COBRA continuation coverage program, the federal government will generally pay the entire COBRA premium for health insurance from April 1, 2021, through September 30, 2021.
• For 2021, if a taxpayer receives unemployment compensation, the taxpayer is treated as an applicable taxpayer for purposes of the premium tax credit, and the household income of the taxpayer is favorably treated for purposes of determining the amount of the credit.
• Persons who bought their own health insurance through a government exchange may qualify for a lower cost through December 31, 2022.

Student loan tax relief

For student loans forgiven or cancelled between January 1, 2021, and December 31, 2025, discharged amounts are not included in taxable income.

Child tax credit

• For 2021, the credit amount increases from $2,000 to $3,000 per qualifying child ($3,600 for qualifying children under age 6), subject to phaseout based on modified adjusted gross income. The legislation also makes 17-year-olds eligible as qualifying children in 2021.
• For most individuals, the credit is fully refundable for 2021 if it exceeds tax liability.
• The Treasury Department is expected to send out periodic advance payments (to be worked out by the Treasury) for up to one-half of the credit during 2021.

Child and dependent care tax credit

• For 2021, the legislation increases the maximum credit up to $4,000 for one qualifying individual and up to $8,000 for two or more (based on an increased applicable percentage of 50% of costs paid and increased dollar limits).
• Most taxpayers will not have the applicable percentage reduced (can be reduced from 50% to 20% if AGI exceeds a substantially increased $125,000) in 2021. However, the applicable percentage can now also be reduced from 20% down to 0% if the taxpayer's AGI exceeds $400,000 in 2021.
• For most individuals, the credit is fully refundable for 2021 if it exceeds tax liability.

Earned income tax credit

For 2021 only:

• The legislation generally increases the credit available for individuals with no qualifying children (bringing it closer to the amounts for individuals with one, two, or three or more children which were already much higher).
• For individuals with no qualifying children, the minimum age at which the credit can be claimed is generally lowered from 25 to 19 (24 for certain full-time students) and the maximum age limit of 64 is eliminated (there are no similar age limits for individuals with qualifying children).
• To determine the credit amount, taxpayers can elect to use their 2019 earned income if it is more than their 2021 earned income.

For 2021 and later years:

• Taxpayers otherwise eligible for the credit except that their children do not have Social Security numbers (and were previously prohibited from claiming any credit) can now claim the credit for individuals with no qualifying children.
• The credit is now available to certain separated spouses who do not file a joint tax return.
• The level of investment income at which a taxpayer is disqualified from claiming the credit is  increased from $3,650 (as previously indexed for 2021) to $10,000 in 2021 (indexed for inflation in future years).

If you would like to review your current investment portfolio or discuss any other financial planning matters, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Should You Hit the Pause Button on Filing Your 2020 Tax Returns?

Note: Since the original publication of this article, the IRS announced that the federal income tax filing due date for individuals for the 2020 tax year is automatically extended until May 17, 2021.

As you likely know, President Joe Biden signed his sweeping $1.9 trillion Covid-19 economic relief package into law on Thursday afternoon March 11, 2021. Included in this package were several tax provisions that increase child tax credits and exempt certain 2020 unemployment benefits from taxation for lower income taxpayers.

Passing retroactive tax legislation just five weeks before the regular 1040 tax deadline of April 15, 2021, is virtually unprecedented, and has left the IRS and tax preparation software vendors scrambling to update calculations, guidance, tax forms, publications and program logic.

Add to the foregoing the IRS' backlog of taxpayer correspondence and flood of erroneous taxpayer notices and you can understand that this has prompted the American Association of CPA's to urge the IRS to extend the tax deadline for filing and payment until June 15, 2021, or at least provide guidance to taxpayers on their thinking about whether they are considering extending the tax deadline.

I was notified today that my own tax preparation vendor, Thomson Reuters, "highly recommends that no returns be filed at this time" due to the preliminary draft nature of several forms (which are based on 2019 forms and not yet approved for filing by the IRS) and the last minute passage of tax legislation. Make no mistake, updating the form calculations and logic is no small feat, especially considering that the IRS has issued scant guidance given that the legislation is still a "newborn".

I imagine that things will look better in a couple of weeks, but if you're anxious to file your returns in hopes of receiving a higher stimulus check, I can only advise you to cool your heels and, if applicable, save yourself a fee to have an amended return prepared. Eventually, you'll receive every penny of stimulus you're entitled to, albeit perhaps on next year's tax return. Given that stimulus payments are due to start arriving this weekend, rushing to file your return will have virtually no effect on the amount of the stimulus check you'll receive over the next month.

If you filed your return early, only your tax preparer can advise you if you'll need to amend that return to take into account the most recent tax changes. If you have a very simple return (Form W-2 and no deductions), my guess is that you're OK. If you received unemployment compensation in 2020, then you may need to file an amended return to claim a refund of overpaid taxes.

My standard advice to clients is not to file prior to March 15 each year (because of last minute issuance and changes to 1099s), and it appears that will now extend until at least March 31. I highly recommend that you do the same.

If you would like to review your current investment portfolio or discuss your 2020 tax return, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

Making Your Money Last In Retirement

Quick Questions: How much can you safely withdraw each year from your retirement portfolio without the risk of running out of money before you run out of life? How much should you withdraw if you don't want to leave too much money behind when you die?

If you're as perplexed about answering these questions as many financial planners are, then this article will help update you on the latest research in this area of retirement planning. Saving for retirement is not easy, but using your retirement savings wisely can be just as challenging. Withdraw too much and you run the risk of running out of money. Withdraw too little and you may miss out on a more comfortable retirement lifestyle.

For more than 25 years, the most common guideline has been the "4% rule," which suggests that a yearly withdrawal equal to 4% of the initial portfolio value, with annual increases for inflation, is sustainable over a 30-year retirement. This guideline can be helpful in projecting a savings goal and providing a realistic picture of the annual income your savings might provide. For example, a $1 million portfolio could provide $40,000 of income in the first year, with inflation-adjusted withdrawals in succeeding years.

The 4% rule has stimulated a great deal of discussion over the years, with some experts saying that 4% is too low, and others saying it's too high. The most recent analysis comes from the man who studied it, financial professional William Bengen (widely considered in the financial planning profession as the "father of the safe withdrawal rate"), who believes the rule has been misunderstood and offers new insights based on new research.

Original Research

Bengen first published his findings in 1994, based on analyzing data for retirements beginning in 51 different years, from 1926 to 1976. He considered a hypothetical, conservative portfolio comprised of 50% large-cap stocks and 50% intermediate-term Treasury bonds held in a tax-advantaged account and rebalanced annually. A 4% inflation-adjusted withdrawal was the highest sustainable rate in the worst-case scenario — retirement in October 1968, the beginning of a bear market, and a long period of high inflation. All other retirement years had higher sustainable rates, some as high as 10% or more (1).

Of course, no one can predict the future, which is why Bengen suggested that the worst-case scenario as a sustainable rate. He later adjusted it slightly upward to 4.5%, based on a more diverse portfolio comprised of 30% large-cap stocks, 20% small-cap stocks, and 50% intermediate-term Treasuries (2).

New Research

In October 2020, Bengen published new research that attempts to project a sustainable withdrawal rate based on two key factors at the time of retirement: stock market valuation and inflation (the annual change in the Consumer Price Index). In theory, when the market is expensive, it has less potential to grow, and sustaining increased withdrawals over time may be more difficult. On the other hand, lower inflation means lower inflation-adjusted withdrawals, allowing for a higher initial rate. For example, a $40,000 first-year withdrawal becomes an $84,000 withdrawal after 20 years with a 4% annual inflation increase, but just $58,000 with a 2% annual increase.

To measure market valuation, Bengen used the Shiller CAPE, a cyclically adjusted price-earnings ratio for the S&P 500 index developed by Nobel laureate Robert Shiller. The price-earnings (P/E) ratio of a stock is the share price divided by its earnings per share for the previous 12 months. For example, if a stock is priced at $100 and the earnings per share is $4, the P/E ratio would be 25. The Shiller CAPE divides the total share price of stocks in the S&P 500 index by average inflation-adjusted earnings over 10 years.

5% rule?

Again using historical data — for retirement dates from 1926 to 1990 — Bengen found a clear correlation between market valuation and inflation at the time of retirement and the maximum sustainable withdrawal rate. Historically, rates ranged from as low as 4.5% to as high as 13%, but the scenarios that supported high rates were unusual, with very low market valuations and/or deflation rather than inflation (3).

For most of the last 25 years, the United States has experienced high market valuations, and inflation has been low since the Great Recession (4)(5). In a high-valuation, low-inflation scenario at the time of retirement, Bengen found that a 5% initial withdrawal rate was sustainable over 30 years (6). While not a big difference from the 4% rule, this suggests retirees could make larger initial withdrawals, particularly in a low-inflation environment.

One caveat is that current market valuation is extremely high: The S&P 500 index had a CAPE of 34.19 at the end of 2020, a level only reached (and exceeded) during the late-1990s dot-com boom and higher than any of the scenarios in Bengen's research (7).  His range for a 5% withdrawal rate is a CAPE of 23 or higher, with inflation between 0% and 2.5% (8) (Inflation was 1.2% in November 2020 (9)). Bengen's research suggests that if market valuation drops near the historical mean of 16.77, a withdrawal rate of 6% might be sustainable as long as inflation is 5% or lower. On the other hand, if valuation remains high and inflation surpasses 2.5%, the maximum sustainable rate might be 4.5% (10).

It's important to keep in mind that these projections are based on historical scenarios and a hypothetical portfolio, and there is no guarantee that your portfolio will perform in a similar manner. Also remember that these calculations are based on annual inflation-adjusted withdrawals, and you might choose not to increase withdrawals in some years or use other criteria to make adjustments, such as market performance. For example, some retirees, in an effort to reduce withdrawals after a "down" year in the market, forego taking an inflation-based increase for the following year.

Although there is no assurance that working with a financial professional will improve your investment results, a professional can evaluate your objectives and available resources and help you consider appropriate long-term financial strategies, including your withdrawal strategy.

If you would like to review your current investment portfolio or discuss your current or upcoming withdrawal rate, please don’t hesitate to contact us or visit our website at http://www.ydfs.com. We are a fee-only fiduciary financial planning firm that always puts your interests first.  If you are not a client yet, an initial consultation is complimentary and there is never any pressure or hidden sales pitch. We start with a specific assessment of your personal situation. There is no rush and no cookie-cutter approach. Each client is different, and so is your financial plan and investment objectives.

(1)(2) Forbes Advisor, October 12, 2020

(3)(4)(6)(8,)(10) Financial Advisor, October 2020
(5)(9) U.S. Bureau of Labor Statistics, 2020
(7) multpl.com, December 31, 2020

Disclaimer: All investments are subject to market fluctuation, risk, and loss of principal. When sold, investments may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest. The principal value of Treasury securities fluctuates with market conditions. If not held to maturity, they could be worth more or less than the original amount paid. Asset allocation and diversification are methods used to help manage investment risk; they do not guarantee a profit or protect against investment loss. Rebalancing involves selling some investments in order to buy others; selling investments in a taxable account could result in a tax liability.

The S&P 500 index is an unmanaged group of securities considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Actual results will vary.