We recently had a meeting with the people who manage our pension funds. It was this meeting that spurred me to write this post.
I was told that if our portfolio earns 3.8% per year, we'll be in excellent shape. They went on to tell us that 3.8% seemed like a reasonable expectation for a conservative portfolio like ours.
First of all, I'm not convinced that 3.8% is a reasonable expectation. I'm not sure interest rates will go that high again for quite some time.
More important though is that if rates of return on very conservative portfolios do go up to 3.8%/yr, it will be because of inflation and inflationary expectations.
Interest rates are and have been low for the past few years because people don't expect much inflation. If and when inflationary expectations increase, then interest rates will rise: lenders will demand higher rates to compensate for the lost purchasing power of the money being repaid, and borrowers will be willing to pay higher rates because they want to borrow to buy now to beat expected price increases.
The impact of inflationary expectations on interest rates has been known for a long time. It was probably first made clear by Irving Fisher with the following equation. In words,
The nominal (or actual, stated) rate of interest = the expected rate of inflation plus the real rate of interest (which is what the nominal interest rate would be in the absence of any inflation):
iN = E(%ΔP) + iR
It looks as if the real rate of interest these days is somewhere between 1.5% and 2%, meaning that a rate of return of 3.8% would be consistent with an expected rate of inflation around 1.5-2% as well.
If so, then to say we'll be okay must also take into account the rate of inflation. To say our monthly withdrawals of $X will last Y years at 3.8% without accounting for inflation would be a mistake.
Either expected inflation must be used to adjust the $X withdrawals, or the calculations should use a lower rate of return, more in keeping with the expected real interest rate, say down around 2%/yr.