Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How to Protect Your Early Retirement from Inflation
Transcript
- Lucas: If you retired in early 2021 with a million-dollar portfolio and a plan to spend forty thousand a year, by mid-2026 the same basket of goods would cost you about fifty thousand dollars. That's a twenty-five percent erosion in purchasing power in just over five years. Luna: And that's assuming you stuck to your forty thousand. Most people wouldn't—they'd feel the pinch and adjust. But the core question is: how do you build a retirement plan that doesn't quietly fail when inflation runs hot? Lucas: Exactly, and the classic four percent rule was never designed to handle the inflation we saw in 2021 and 2022. William Bengen, who created the rule, assumed inflation would average around three percent. It hit over nine percent in 2022. So retirees who relied on that framework got squeezed from both sides—higher prices and a stock market that dropped. Luna: So what's the fix? I've heard people talk about TIPS—Treasury Inflation-Protected Securities. But they've had a reputation for low yields. Lucas: They did, for a long time. But after the 2022 rate hikes, TIPS yields actually turned positive. A five-year TIPS recently yielded around one point eight percent above inflation. That's not a home run, but it's a lot better than the negative real yields we saw in 2020. And the real value isn't in the yield—it's in the structure. Luna: Structure meaning you know your principal keeps up with inflation? Lucas: Right. The principal adjusts with the Consumer Price Index, and at maturity you get back either the adjusted principal or the original, whichever is higher. So deflation doesn't kill you either. But the way I think retirees should use TIPS is through a bucket strategy. You take your essential spending—say, forty thousand dollars a year for groceries, utilities, insurance—and you cover that for three to five years with a ladder of TIPS that mature each year. Luna: So the rest of the portfolio stays in equities and maybe real estate, where you get growth. Lucas: Exactly. The bucket protects you from sequence risk—you're not forced to sell stocks when the market's down—and it also protects your purchasing power because the TIPS payments rise with inflation. Let's say you have a one point two million dollar portfolio. You put two hundred thousand into a five-year TIPS ladder that covers forty thousand in essential expenses each year. That leaves a million in stocks and real estate. Luna: And the stocks can ride out downturns without you having to touch them. Lucas: That's the idea. In the worst sequence of returns scenario—retiring just before a crash—you're drawing from the TIPS bucket for five years. By the time that bucket runs out, the stock market has likely recovered. And because the TIPS are inflation-adjusted, your essential spending keeps up with the cost of living. Luna: But what happens after year five? You'd need to replenish that bucket, which means selling stocks at that point. Isn't that just delaying the sequence risk? Lucas: It is a valid concern. The way to handle it is to refill the bucket gradually when the market is doing well—not all at once. You set a rule: when the portfolio is up more than ten percent in real terms, you sell some growth assets and buy more TIPS to extend the ladder. You're essentially dollar-cost averaging out of equities during good times. Luna: That makes sense. It's like you're always keeping five years of safety net, but you never sell at the bottom. Lucas: Precisely. And there's data backing this. Researchers at Morningstar ran simulations comparing a straight sixty-forty portfolio to one with a TIPS bucket. Over the worst historical periods—including the 1970s—the bucket strategy had a higher success rate and left more money on the table in the long run. Luna: What about I bonds? Those are another inflation-protected option, and they have tax advantages if used for education, but for retirees? Lucas: I bonds are great for building a cash buffer because the interest is tax-deferred until you redeem them. But there's a ten thousand dollar per person per year purchase limit, so you can't build a large ladder quickly. For a couple, you could get twenty thousand a year, which is decent, but it would take years to build a five-year bucket. TIPS don't have that limit. Luna: Plus I bonds have a penalty if you redeem before five years. Lucas: Right, three months of interest. So they're better for a long-term emergency fund, not a precise income ladder. For someone already retired or retiring soon, TIPS are more practical. Luna: Let's talk about the other side of the equation: spending. If inflation is high, do you just accept that your spending goes up, or do you try to keep it constant in real terms? Lucas: That's the debate. The traditional approach is to increase your spending each year by the inflation rate. But that can be dangerous if inflation spikes. Some retirees use a fixed percentage of portfolio—like three and a half percent of the current balance each year. That automatically adjusts your spending down when markets fall and up when they rise. Luna: But then your spending can be volatile. One year you're traveling, the next you're cutting back. Lucas: That's the trade-off. But studies show that retirees actually spend less as they age—the so-called 'retirement spending smile.' They spend more in early retirement on travel and hobbies, then less in their seventies, then more again in their eighties on healthcare. So a fixed real spending amount might not match your actual needs. Luna: So maybe the bucket approach gives you the best of both: you keep essential spending inflation-adjusted and stable, and you let discretionary spending fluctuate with the market. Lucas: That's what I recommend. Your essential bucket—TIPS ladder—covers the must-pay bills. Everything else—travel, dining out, gifts—comes from the growth portfolio. You spend what the market allows. In good years, you spend more. In bad years, you tighten up. That flexibility is what makes early retirement resilient. Luna: I want to circle back to something you said about the 1970s. That was the stress test for any retirement plan. How did the bucket strategy hold up in those simulations? Lucas: Surprisingly well. The key was that TIPS didn't exist then, so the simulation used actual Treasury bills and short-term bonds. But even with that proxy, having a cash buffer protected retirees from selling stocks at the worst moments. The portfolios that failed were the ones that kept all their money in stocks and bonds and tried to pull a constant percentage. Luna: It's interesting how often the solution comes back to having a buffer. We've talked about cash buffers, bond tents, and now inflation-protected buckets. It's like the unifying theme of early retirement. Lucas: It's really about managing risk. Sequence risk, inflation risk, longevity risk—all of them are addressed by having a layer of safe assets that let your growth assets do their job over time. And I think it's worth noting that we're able to have these conversations without any ads or sponsors pushing products. Luna: That's a big deal. Most personal finance shows are hawking something—a robo-advisor, a credit card, a course. We deliberately don't. And if listeners find that valuable, they can support the show at buy me a coffee dot com slash fexingo. Lucas: It's a way to keep these episodes independent and focused on what actually works. So let's get back to the practical side. If you're a listener thinking about implementing this, here's a starting checklist. First, calculate your essential annual expenses—the ones you can't avoid. Second, multiply that by three to five years. That's your bucket size. Luna: And then you buy TIPS that mature in each of those years, right? Lucas: Exactly. You can buy individual TIPS through a brokerage account. Just look for ones with maturities that match your spending years. The interest payments will be small and taxable, but the principal will keep up with inflation. Third, decide on a refill rule. I like the ten percent gain rule I mentioned. When your portfolio is up more than ten percent in real terms, you sell enough to extend the bucket by one more year. Luna: What about taxes? You mentioned TIPS interest is taxable annually, even though you don't get the cash until maturity for the inflation adjustment. Lucas: That's the phantom income problem. The inflation adjustment is taxable each year as ordinary income, even though you don't receive it until maturity. So you should hold TIPS in tax-advantaged accounts like an IRA if possible. If you have to hold them in a taxable account, keep the bucket size small enough that the tax bill doesn't surprise you. Luna: Okay, so TIPS in an IRA, equities in taxable for the lower capital gains rates, and a refill rule. That's a solid framework. Lucas: One more thing: don't forget about healthcare costs. They tend to rise faster than general inflation. Some studies show medical inflation running two to three percent higher than CPI. So if you're covering health insurance until Medicare kicks in, factor that into your essential bucket. Luna: And after Medicare, there's still premiums and out-of-pocket costs. Those increase too. Lucas: Right. So maybe you want a separate healthcare bucket or a higher allocation to growth assets to outpace that specific inflation. The important thing is to be intentional. Inflation isn't going away, and pretending it's not a risk is the quickest way to run out of money in your eighties. Luna: I think a lot of early retirees focus on the accumulation phase and don't spend enough time on the decumulation phase. This episode should help with that. Lucas: That's the hope. Next time, maybe we'll talk about how to adjust your bucket when interest rates change. Because if TIPS yields go up, your ladder gets cheaper to build, and that changes the math.