The Pension Series (Part 7): How to Create Your Own COLA

St. George’s Thesis

Build Your Own Cola

“Cry — God for Harry! England and Saint George!”

How was your week? Productive I hope.  I spent most of my spare time drafting my pièce de résistance for the Pension Series as a guest post for one of my favorite blogs and bloggers. I’m excited, so stay tuned for the announcement as to when and where you can find it. Unfortunately, it means I’m short an article because I (stupidly) don’t keep any posts in the bank.

However, I am about to let you in on a little blogging secret.  Facebook provides an endless amount of material to write about. As proof of this point, about 10 days ago George, one of my awesome Golden Albatross Facebook Group members, asked the following sizzler of a question related to pensions and inflation-adjusted Cost of Living Allowance (COLA):

Basically, if my pension is say $50k [a year] with no COLA provided by my employer, what do I have to have saved in an IRA to be able to grow my pension with cost of living for the next 30 years? (50k+4%)+4%)+4%)etc. For 30 years…)

He was essentially asking how to build his own inflation-adjusted COLA. It was a great question, the importance of which I grasped intuitively since I’ve recently blogged several times about the nefarious effect that inflation can have on a pension. But the potential math associated with George’s question made my head hurt. As much as I like to masquerade as some sort of evidence-based statistics-loving nerd (which I mean in both the nicest and most envious way possible), the truth is my knuckles scrape the ground when I walk. Fortunately, they are furry, so the pavement doesn’t do much damage.  Didn’t I mention I was a liberal arts major in one or two of my previous posts?

Build Your Own COLA

I took a selfie.

Context is Everything

All joking about my potential chromosomal linkage to our Simeon cousins aside, the idea behind George’s question is nothing new to the Financial Independence (FI) space. In fact, one might argue it’s one of the fundamental ideas that drives the FI community. It’s the idea of replacing the guaranty of a Defined Benefits Pension (DBP) with some sort of Do-It-Yourself (DIY) hack. Whether it’s the examination of the value and limits of purchasing an annuity to replace the steady income that a DBP historically provided workers by bloggers like Darrow Kirkpatrick at Can I Retire Yet. Or the thousands of articles written by bloggers like the Mad Fientist, Michael Kitces, JL Collins, Mr. Money Design, and Ern McCracken about Safe Withdrawal Rates (SWRs) from investments. Everyone is striving for the same goal: creating a reliable income stream in retirement much like a DBP.

The difference in George’s question though is that he has a potential DBP coming his way in the not so distant future, so he is not looking for a way to replace the entire income of a pension.  He just doesn’t have an associated COLA to accompany the pension.  This means inflation will eat away at the value of his pension on an annual basis making his hypothetical $50K less valuable each year. For instance, if George simply started taking his hypothetical $50K pension this year, without an inflation-linked COLA, in 40 years at a 2% annual inflation rate, the purchasing power of his pension would equal $22,644.52 in today’s dollars. Ouch! That’s over a 50% reduction in value. Thus, George is astute to inquire as to how to amass his own pot of money that he can use to create his own inflation-linked COLA.

build your own COLA

COLA and lime to ease the pain from inflationary pressures anyone?

Given my above-mentioned lack of math skills, answering George’s question wasn’t going to be easy.  My extensive research (i.e. 10 minutes on Google) turned up zero articles addressing George’s topic (I did find some awesome DIY Coca-Cola recipes though). I’m not surprised since it’s a somewhat complex question about a DBP, which not many experts look at these days. However, if you think about it, this question has greater application than simply building a DIY inflation-linked COLA for a DBP. If answered, then we’ve identified an inflation defeating investment mechanism for any personal finance product that needs one! I know it’s not world peace, but it possibly opens up some methods for people without pensions to build some fixed income streams and protect them from inflation in retirement.

A Closer Examination

Grow your own COLA

Ah yes, inflation Watson! Inflation! A more resilient foe than Moriarty.

Let’s examine this math problem a little closer. The mathematical complexity isn’t centered on how to execute the COLA payments. That’s simply a matter of George checking the Consumer Price Index-Urban (CPI-U) from the Bureau of Labor and Statics (BLS) either monthly or annually once he’s in retirement. He can then withdraw the appropriate percentage from the investment account he set up for the COLA replicating mechanism.

The real problem is figuring out the initial amount George would need amassed and invested in that COLA replicating mechanism by the time his pension starts. In other words, based on the Initial Dollar Value (IDV) of George’s pension ($50K) he needs X invested at retirement to kick off an SWR that matches CPI-U inflation. Solve for X!  Secondary, but also associated with that problem, is what inflation rate to use as an average? Finally, there’s the question of portfolio allocation to produce that CPI-U inflation rate matched return. I guess I meant to solve X, Y, and Z. Uggghh.

As much as I love a good algebra equation, I felt this called for the skills of a polymath.  Fortunately, I keep one on retain… er … what I really meant is there’s one in my Facebook Group. For some reason known only to himself, Big Ern McCracken is a member of my Golden Albatross Group, for which I am grateful. For those who don’t know Big Ern, he runs the Plutus Award nominated website called Early Retirement Now. He has written, among other things, the definitive series of posts within personal finance circles on the efficacy of the 4% Rule (or as he calls it the 4% Rule of Thumb). Thus, once I wrapped my head around George’s question, I knew if anyone possessed the ability to solve for X, Y, and Z it was Ern.

Ern’s Solution

Ern was game. In fact, he knocked out an initial answer in less than 12 hours, and by 24 hours provided a complete response. Most of that delay was due to the time difference of me living in Hawaii. Luckily, for everyone reading this, Ern gave me permission to reprint his answers here. Thus, I’ve pasted them below in sections using italics. I’ve interspersed my comments in the non-italicized text when I felt context was needed.

Without further delay, let’s get to Big Ern’s most elegant solution to George’s question:

There is no 100% accurate answer. But I can give you a rule of thumb number.

No worries, none of the problems we solve on this website actually have a 100% accurate answer — mostly because I’m doing the math. In fact, we are lucky to get within 50% accuracy.

I couldn’t find a picture of a gorilla with an abacus, so use your imagination.

I normally work with a 3.5% safe withdrawal rate (SWR). That means, in the worst possible case, you’ll need 1/0.035=28.57 per dollar of COLA adjusted payment stream. So, a portfolio of $28.57 invested in an 80/20 portfolio should generate a $1 per year COLA pension.

Right, based on Ern’s previous research on SWRs, the maximum sustainable rate of withdrawal someone can use to take money annually from an investment account with a low probability (less than 3%) of the account running out of money is only 3.5%. This is good through all market conditions. To effect a 3.5% SWR requires George to invest $28.57 for each nominal dollar he needs to spend from his COLA reproducing investment mechanism.

But George is not looking to spend 3.5% annually from his COLA reproducing investment mechanism. If he was, then in the worst case he would need almost $1.5mil invested ($50K x $28.57) at retirement. Fortunately, George is looking to spend at the same rate as inflation, which will hopefully be a lot lower than 3.5%. Thus, Ern needs to determine what value to use for future inflation. Finally, note that Ern’s chosen portfolio allotment is 80% stocks / 20% bonds for this scenario. Let’s see if that will work for Z.

I also estimated that assuming a 2% annual inflation rate a non-COLA pension is worth only about 60-70 cents on the dollar (see link), also worst possible case. Roughly 60 cents on the dollar for a 60-year horizon and 70 cents on the dollar for a 40-year horizon.

Ah, so Ern prefers to use 2% as his projected annual inflation rate (see the inflation section below as to why). We now have Y. Separately, through his previous research, Ern determined that a 2% annual inflation rate’s effect on a non-COLA pension drives the value of that pension down to as little as 60 to 70 cents on the dollar. In other words a haircut in the value of the pension by 30% for a 40-year retirement, and 40% of the value for a 60-year retirement.  Thus, depending on George’s lifespan in retirement he needs to recoup 30% to 40% of the value of his pension through his inflation-linked COLA generating investment mechanism over the same time period.

So, you’ll need around 0.3 to 0.4 times $28.57 to make up for the non-COLA pension, so $8.6 to $11.4 per dollar of annual non-COLA pension in reserves, invested in at least 80% equities, to fund your own COLA payments.

Hang with me here, because this is the most important part.  I double checked this with Ern too, so I know the example below is accurate. What Ern means with this statement is if George retired with a $50K (non-COLA) annual pension, then George needs approximately $8.6 x $50K = $430,000 to $11.4 x $50K = $570,000 invested in an 80/20 stocks to bonds mix the first day of retirement in order for him to pull out 2% annually as a do-it-yourself COLA.  Thus X = $430K to $570K depending on how long George intends to live!

While to some that may appear an eye-watering amount, it’s much better than the worst case 3.5% SWR driven $28.57 x $50K = $1.5mil I referred to above. In fact, I doubt it’s a coincidence that $430K and $570K are 30% and 40% of the approximately $1.5mil figure. So, the even more simplistic Grumpus Maximus rule of thumb for figuring this out assuming a 3.5% SWR and 2% annual inflation rate would be:

  • $28.57 x Pension’s Initial Dollar Value (IDV) = Worst Case Amount (WCA)
    • 40 year Retirement Scenario: WCA x 0.30 = X
    • 60 year Retirement Scenario: WCA x 0.40 = X

Certainly, these amounts are doable, but only if you start early and plan ahead. 30% to 40% of most pension amounts is probably significant. Honestly, running this scenario has given me a new appreciation of a) why DBPs are so rare, and b) why inflation-linked COLAs built into those DBPs are even rarer.  This stuff is expensive! No wonder the private and public sectors in the U.S. have pushed so hard to reduce DBPs.

A Word On Inflation Rates

build your own COLA

We could probably paper the walls with Venezuelan notes right now.

If your one of my regular readers, hopefully, you’ve come to see, like me, that inflation is a pernicious sucker. It can literally suck the life out of the largest pensions, if not accounted for. Thus, in the name of thoroughness for this post, I asked Ern what drove him to use a 2% inflation rate. I looked through his blog but did not see a post with an obvious answer. As a point of reference, 2% is the post-Great Recession rate. Yet, 3.22% is the historical average since the end WWI. Granted, that average trended downwards over most of last and this century, but even a little change upwards in the inflation rate for this scenario could seriously impact the calculations. Ern wrote me back with the following answer:

I use 2% because 1) that’s the prevailing long-term forecast of a lot of professional economists in academia and Wall Street (including myself), 2) it’s the inflation target of the Federal Reserve, 3) it’s close to the implied inflation rate derived from the TIPS [Treasury Inflation Protected Securities] vs. nominal Treasury bonds, 4) the 3.22% long-term historical is tainted by the experience of the 1970s that – hopefully – will never repeat itself.

Fair enough, and all sounds logical. However, I wrote Ern back (again) and asked him how to make the calculations in case George wanted to use the 3.22% historic inflation average to discount the non-COLA pension. I told Ern that I suspected a 3.22% inflation rate probably bumps the numbers up to approximately 40% to 50% of the SWR rate for the initial value of the pension — but I didn’t know how to calculate it. Here was Ern’s final answer:

To run this with 3.22% I’d have to run the whole simulation again, but if I had to give you a ballpark estimate I’d probably agree and apply a haircut of 40-50% of the original numbers using the 2% inflation forecast.

Just so you are all tracking, Ern and I were talking about applying 40% to 50% haircut to the value of George’s initial $50K pension based on a higher inflation rate which would bump up the numbers in our calculations to look something like this:

  • 40% scenario (40 years of retirement): $11.40 x $50K = $570K
  • 50% scenario (60 years of retirement): $14.29 x $50K = $714K

Remember these are ballpark figures, but a 3.22% inflation rate means George would need to save even more money prior to retirement. Exactly what I expected.

Conclusion

Unfortunately, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel (commonly, but mistakenly, referred to as the Nobel Prize in Economics) was already awarded this year. Who is this Richard Thaler guy anyways? What’s he ever done other than redefine how we look at the discipline of Economics? Anyhoo, it gives me, George, and Ern time to prepare speeches and our tuxedos for next year. Actually, I keep my tux prepped and ready to go at all times. Maybe I can wear it to the next Fed meeting when Janet Yellen mistakenly invites me as a reward for all of Big Ern McKracken’s hard work.

“Yes Miss Chairwoman, I agree. That Grumpus Maximus really is the brains of the outfit.”

In all seriousness though, I would like to thank Ern for collaborating on this subject with me. Let’s be honest I didn’t have a hope in hell of figuring out George’s question otherwise. Thank you to George for asking a tough but fun question to delve into as well. If you have a pension/FI related question, don’t hesitate to ask by emailing (grumpusmaximus@grumpusmaximus.com), commenting on the blog, or catching me on Facebook. If its a tough enough question, it will probably get featured at some point. Just make sure you have your tux or ball gown ready though.  You never know when the Riksbank committee will come a calling.

24 thoughts on “The Pension Series (Part 7): How to Create Your Own COLA

  1. Excellent post! This is a hard problem! You have the double uncertainty of market returns and inflation uncertainty. One issue works in your favor though: Sequence of Return Risk. Because you hardly withdraw anything in the beginning and only slowly transition into the withdrawals you would be less worried about SoRR. Maybe even go to 100% equities to have the maximum inflation hedge! My tuxedo is always ready to go if that phone call from Stockholm ever comes! 🙂

    • Thank you Ern. Obviously I couldn’t have written this article without your math skills. I’ve enjoyed delving into this subject with you and hope to do something similar again in the future! Now, where did I put my bow tie and cuffs links?

  2. My initial reaction to this article was something along the lines of “No way! These guys are completely wrong. Math error. Somewhere. Has to be.”

    Unfortunately (for me) the more I tried to follow the calculations the more depressed I got. We have some SS and a decent pension, but it’s non-COLA. We were already planning on living on much less than our total income, so our spending won’t be impacted. But now we’ll have to think differently about the savings/investments we are projecting. Instead of saving up for some future purchase or emergency, it’s really going to have to function as a DIY COLA. I guess it’s good that I read this before we started spending it all!

    • Glenn – Thanks for the note. I’m both happy and sad to hear your story. Happy that the article helped you avoid a miscalculation. Sad to hear that it impacts your plans in such a big way. No doubt about it, inflation is the enemy of savings. Please keep in touch and let me know how things progress with your DIY COLA efforts. Regards, GM

      • Thanks GM. I guess I should clarify a bit. Our income will more than double over the next five years. Our spending will *not* so that we can build a ‘nest egg’ outside of our pension/SS. We planned this in part due to concerns about the long-term viability of both SS and our pension. I don’t consider either one to be at great risk, but the risk is non-zero, so the nest egg is for peace of mind. By the time inflation becomes a worry, say in around fifteen years, we will hopefully be hitting the 7-figure territory.

        If we have to shift our thinking a bit, from “should we buy a home in Mexico” to “I guess we have to tap our funds to cover for this horrible inflation,” then in that sense – it’s not a ‘big’ impact. Just a shift.

  3. My initial reaction was the same as Glenn D. “No way. Half a million to handle the COLA for a $50k pension?”
    I was very interested in this topic, because I am in exactly the same position as George. Just retired at 65, with a $50k pension, and no COLA.
    So I did a spreadsheet, years 1 to 30.
    Put my $50k on first line. Each subsequent year was times 1.02 for a compounded 2% “inflated” pension year by year.
    Next column, was the “deficit” which is the inflation compounded pension number, minus the $50k I am getting.
    Now the question is, what nest egg do I need to make up that deficit?
    So the next column equals “Nest Egg” x compounded rate of return, minus deficit.
    By trial and error, using a compounded rate of return of 8%, and an inflation of 2%, Nest Egg equals $150k. And at the end of 30 years, still has $160k remaining. It goes to zero at year 35 (when I am 90).
    I’ll send you the spreadsheet if you are interested. You can put in a different rate of return instead of my 8%. But I think 80% stocks should get you that.

    P.S. Thanks for your military service. My dad was a B-29 navigator in WW2. So we have always had a lot of respect for our service men and women.

    • Thanks for the note Dwight. I’d love to take a look at your spreadsheet. Alternate analysis is a good thing in my opinion, and your number is a lot different than what we came up with. If there’s a cheaper way to build a COLA, I’m all about it, but I would need to dig into your calculations and test them. I may even pass it to Big ERN if it looks solid. Please email it to grumpusmaximus@grumpusmaximus.com

    • Dwight, I got the spreadsheet you sent, and dug into it over the weekend. I think I understand why your sum was so much smaller than the one Ern and I came up for George. Ern’s formula is built off a Safe Withdrawal Rate (SWR) of 3.5% that fails in less than 3% of the historical market scenarios that he uses when testing all of his case study numbers against. There is a much higher threshold for saving to get to a SWR with such a small failure rate in comparison to all historical scenarios. In other words, you have to save a lot more to guarantee against the worst historical scenarios like the Great Depression, and the hyperinflation of the 1970s.

      The main risk is Sequence of Return Risk (SRR). SRR basically means the market tanks right as you go to withdraw your first DIY COLA payment. The effect of SRR is that if the market were to tank in year one of your withdrawals, but you withdrew the full DIY COLA amount regardless, you run a serious risk of compromising your future likelihood of success because making withdrawals while the market is down withdraws a significantly larger percentage of your nest egg than when the market is up.

      Since your 8% average rate of return spreadsheet doesn’t account for SRR; you’ve basically painted the best case withdrawal scenario. Throw in any standard of deviation (i.e. market volatility) into your scenario, and it falls apart. In fact, I ran your scenario through my preferred high powered retirement calculator, and it failed 40% of the time with a standard deviation as small as 1% from from your 8% average rate of return. Not good. In fact, just eyeballing it in my retirement calculator, if I use the SP 500’s Combined Annual Growth Rate (CAGR) of 9.5% and its historical standard deviation of 19.7% in this scenario, you’d need roughly $650K invested to make it 30 years with a 97% success rate. BTW, I got those numbers at this article at Seeking Alpha (https://seekingalpha.com/instablog/605212-robert-allan-schwartz/4831186-annual-returns-s-and-p-500-1928-2015)

      I also noticed you used a spend to zero scenario, which Ern and I did not employ in our original case study. At least I don’t think we did — he’d have to confirm that. However, the example I just ran for you above, does. The importance of a spend to zero scenario is that it allows a much higher withdrawal rate, or inversely, a much smaller nest egg to start with. Thus, it’s another reason your reason your number was so much lower than ours.

      BTW, if you want an excellent book on this entire subject, I would suggest “How Much Can I Spend in Retirement?” by Wade Pfau. I’m lucky, because I only just read it a few weeks ago. If I hadn’t, I wouldn’t have been able to explain this issue nearly as well. However, all that said, thanks for the challenge. You had me sweating and scratching my head for a good couple of days!

    • My pension has a COLA and I am familiar with inflation. As a self-taught investor, I eliminated advisor fees and lowered expense ratio fees because I understood how those fees can compound and each away your retirement savings. I find it strange that 1) I never thought of inflation as compounding so thank you and 2) I don’t have a tuxedo. As always, thank you for the information, education, and your service to our country!

      • Compounding inflation is a total head trip. I almost made a fatal error in my book about it, but fortunately it was caught in editing. That said, I think a tuxedo is a good investment if you live in a place where you have regular need for them. When I was stationed in Europe as a exchange officer, there were tuxedo events about once a quarter, so it made sense. However, in small regional city NZ, there are few uses for a tux, at least in the circles I travel in. That’s a good thing since I outgrew the tuxedo that I referenced in the post. By which I mean my waistline expanded too much. The slowing metabolism that comes with middle age sucks!

  4. I think I found a flaw in your numbers. It’s in this paragraph:

    “What Ern means with this statement is if George retired with a $50K (non-COLA) annual pension, then George needs approximately $8.6 x $50K = $430,000 to $11.4 x $50K = $570,000 invested in an 80/20 stocks to bonds mix the first day of retirement in order for him to pull out 2% annually as a do-it-yourself COLA.”

    If George pulls 2% out of his $570k COLA investment, that would be $11,400. But George just needs 2% of his $50,000 pension, which would be just $1,000 in year 2, then climbing from there. He won’t need over $11k until year 12, $58k in year 40. I’m not sure how this would impact the total nest egg levels needed

    • There is no flaw in the numbers. I did the simulations on how much of a haircut you have to give to a non-COLA cash flow vs. the COLA cash flow. So, the calculation I did is exactly what you propose: pull out ever increasing amounts from the $430k to $570k to make up for the declining real value of the non-COLA pension. The first year nothing. The second year $1,000, the third year $2,020, in the n-th year 50000*1.02^(n-1)-50000. Nowhere did I ever suggest withdrawing $11,400.

      • Love the built in “shield” for SORR in the first years for the DIY COLA which, if the AA is 80/20 with rebalancing, should help my wife and I sleep a bit better! Thanks for your contributions to the article and helping those of us with upcoming non-COLA pensions to prepare and plan accordingly.

        Now we’re on to the next item of study: whether or not it makes fiscal sense to purchase additional years of service at retirement…

  5. Thanks for this post. I went through a related calculation because I have a defined benefit plan that starts when I turn 62, but it has only a 1% COLA. At 70, my Social Security and required withdrawals kick in, so I’m less worried about inflation after 70. I wanted better protection against inflation from age 62-70 for 50K (which was also the amount in your hypo), so I decided to set aside an inflation reserve that I now longer consider part of portfolio because, in effect, it is earmarked (like a sinking fund) for those future costs. This required 1) determining what those future inflation costs (and their present values) are and 2) funding the expenses. The attached table shows how I did the calculation, though the columns may be a bit screwed up. I could imagine the formula needed, but I’m less mathematically sophisticated than you, so I manually calculated how much I would need each of those 8 years to preserve the purchasing power of 50K. Then I calculated the present value (to today) of each of those payments and added it up. I did the calculation assuming 3% inflation and also 2%. I decided to go with the 2% number and removed from my Personal Capital dashboard funds equal to that amount. Does this calculation make sense? One way to fund this series of increasing annual costs would be by (today) buying a series of discounted zero-coupon instruments that matured each year in the amount of that year’s inflation cost. Analytically that makes sense, but I could not find those exact instruments out there.

    Does this make sense?

    BRIDGE FINANCING (62-70) (INFLATION)

    YEARS
    FROM NOW YEAR COLA
    3% COLA
    2% $50,000 PRESENT VALUE OF STREAM OF 3% COLAS PRESENT VALUE 2% COLA STREAM
    First column =years from now
    Second column = year of inflation charge and my age
    Third column = nominal inflation cost of 50K at 3%
    Fourth column = PV of that number
    Fifth column = Future value of 50K that year
    Sixth column = nominal inflation cost of 50K at 2%
    Seventh column = PV of that number

    Bottom line: For those 8 year, I would need $58,000 in nominal dollars to fund a 3% inflation supplement, whose present value is
    (conservatively) is 42K. For 2% inflation, the PV is 28K.

    6 2025 (62-63) $1,500 $990 $51,500 $1,256 $828
    7 2026 (63-64) $3,045 $2009 $53,045 $2,475 $1633
    8 2027 (64-65) $4,636 $54,636 $3,659 $2414
    9 2028 (65-66) $6,275 $56,275 $4,809 $3173
    10 2029 (66-67) $7,963 $57,963 $5,925 $3910
    11 2030 (67-68) $9,701 $59,701 $7,008 $4625
    12 2031 (68-69) $11,492 $61,492 $8,060 $5319
    13 2032 (69-70) $13,336 $8801 $63,336 $9,081 $6468
    Total nominal $57,848 $42,273 (in 2019 dollars) $28,370

    • Jose –

      Without being able to see your spreadsheet, your process looks logical. As I did a cursory review of your numbers and values, the outcome seemed reasonable. The only thing I might suggest is that you take your 3% and 2% values in 2019 dollars ($42K and $28K), and then run them through a high powered investment or retirement calculator — something that allows you to play with stock market volatility and inflation. If you can find that type of tool, then try growing your 2019 3% and 2% values ($42K and $28K) to the $58K Future Value that your calculations showed you needed. However, when you run your simulations, try throwing in some stock market volatility. I would guess that doing so it will alter your chances of success.

      Another reader wrote in about this same article, and stated he could not reproduce the results of ERN’s calculations. Yet, when I investigated, it turned out that the reader didn’t use a formula that took stock market volatility into account. In other words, the reader was lowballing his required total because he used a straight 7% stock market return. When I ran his numbers through Flexible Retirement Planner (FRP), and then added volatility, this reader’s numbers soon fell apart (i.e. produced low probabilities of success).

      If you do this, let me know what the results are. I’d be interested hear.

      Regards,

      GM

  6. My pension has a COLA and I am familiar with inflation. As a self-taught investor, I eliminated advisor fees and lowered expense ratio fees because I understood how those fees can compound and each away your retirement savings. I find it strange that 1) I never thought of inflation as compounding so thank you and 2) I don’t have a tuxedo. As always, thank you for the information, education, and your service to our country!

  7. This is awesome! Thank you! I work in a union with a pension plan, no COLA. This was exactly what I was looking for and I trust Mr. Big Ern.

  8. This was so enlightening! We have a 1% Cola. If we use 2% inflation for the 40 year period, is it safe to assume the nest egg would only need to be half of your calculation since 1% of the 2% is covered by the COLA? That 80/20 mix is another hurdle–I assume anything less in equities requires a larger nest egg, but that gives me great pause! Best to separate the required amount from the rest of the portfolio knowing it needs to be at that risk level and carry on with what is left at my comfort level which is about 30-40% stock! Thank you for this article!

    • Karen,

      To be totally honest, much like I said in the article, I’m no math genius, so I’m not sure I can even give you a correct answer.

      But … what I can tell is that I don’t think you can just cut what you need to save in half simply because the inflation rate for your scenario is a nominal 1% instead of 2%. I say that because you are dealing with the effects of compounding rates of inflation, which is much like compound interest, but in the opposite direction. Therefore, the negative effects of a 1% and 2% inflation rate compounded annually on any sum of money do not equal multiples/divisors of two from each other.

      For instance, $100,000 in today’s dollars deflated annually at 2% for 40 years equals $45,289.04 in today’s dollars. That’s a drop of $54,710.96 in purchasing power from start to finish. However, $100,000 in today’s dollars deflated annually at 1% for 40 years equals $67,165.31 in today’s dollars. That’s only a $32,834.69 drop in purchasing power from start to finish.

      As you can see, $32,834.69 is not half of $54,710.96. In fact, it’s roughly 60%. That’s the effect of compounding, which, in this case, is the deflationary effect of inflation on purchasing power.

      So, assuming a 50% reduction probably (again, no math genius here) isn’t the correct answer, but what is the right one? Unfortunately, I don’t know, although I bet someone better at math can help you figure it out. On the other hand, maybe you think the differences are close enough to each other that 50% puts you in the same ballpark. That’s your decision. I would caution you, though, since the scenario in my blog post already made a lot of assumptions and approximations. Adding even more on top of those, probably isn’t all that safe.

      Hope this helps!

      Regards,

      GM

  9. So if this amount is in a tax deferred account, you will need to account for taxes which will increase the amount needed depending on your marginal tax rate or your tax bracket, correct? So even if in the 12% bracket, with 7 % state, we need almost 20% more than the calculated amount if we are using money in a Traditional IRA or 401k?! I hope I am wrong!

    • CB,

      I don’t think you are wrong. You need to account for taxes. And, as you correctly point out, accounting for taxes depends on the type of account a pensioner uses to build their DIY COLA. If it’s in a taxable account, then withdrawals would be taxed as long-term capital gains at both Federal and state level. If it’s in a Traditional (tax-deferred) retirement vehicle like an IRA, then your withdrawals are taxed as normal income. If it’s in a Roth vehicle, withdrawals are not taxed. In my mind, traditional retirements vehicles are probably the least well suited for pensioners to build a DIY COLA, since pension payments are going to fill up the 0% tax bucket and spill over into the higher marginal tax brackets. Others would argue traditional retirement vehicles are the best to amass wealth in because it gets you to your number quicker (since taxes aren’t taken out before investing, thus allowing more money to compound over time). At the end of the day, it all depends on what you think your tax situation is going to be in retirement. But, as a pensioner, you have far less tax room to maneuver and must take taxes into account if you want to build an accurate COLA.

      Regards,

      GM

  10. GM,
    I’m back at this very informative article and am wondering if you’ve had any follow-up with these inflation rates over the last year and a half. Any thoughts on if using the 2% is still “safe” over a 30-40 year period, or if that should be upped to the 3.25 at a minimum or even higher (sigh)? I know it is the unknown and there are so many what-ifs, but is there a general consensus? Also, if I can’t stomach the 80/20, is there a way to determine the dollar amount needed for a 50/50 mix (understand it will be higher than the $28.57 per dollar amount but wondering how much higher and where would I go to determine this?) Again, thanks from a math challenged newly retired couple that needs to definitely put something in place for a DIY COLA! Thanks for the insight!

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