Why are portfolio withdrawals lower than expected in a plan with a non-portfolio income source that is not adjusted for inflation?

The "spending capacity" calculated for Income Lab plans accounts for everything unique to that plan, including the characteristics of a household's non-portfolio income sources. The total spending capacity and total portfolio withdrawals in the plan will depend on these characteristics. So, we'd expect different levels of portfolio withdrawals depending on whether a non-portfolio income source is:

1. Adjusted for inflation
2. Not adjusted for inflation
3. Has an annual fixed inflation adjustment (or "cost of living adjustment")

The Income Lab app accounts for the fact that future inflation is uncertain and variable (inflation assumptions, including standard deviations, can be set in capital market assumptions). The differences between the portfolio withdrawals in plans with different types of non-portfolio cash flows reflect this fact.

For example, let's look at a plan that includes a $1 million portfolio alone, and no other income sources, and allows for about $3590/month in portfolio withdrawals.

Inflation-Adjusted Pension

To this we can add an inflation-adjusted (and, in this case, joint-life) pension of $2000 and get, as we might expect, $5590/month in income. (Please see Why are portfolio withdrawals lower than expected in a joint plan with cash flows that change when a spouse dies? for information on non-portfolio cash flows that aren't steady through both spouses' lives.)

Not-adjusted-for-inflation Pension

But, if this pension provides $2000/month in today's dollars but does not enjoy inflation adjustments in the future, the plan will provide only $2820 in withdrawals. This is $770/month less than in the plan with an otherwise-identical inflation-adjusted pension. That $770/month is the cost of offsetting future inflation risk for this household.

Annual COLA

If this pension provided for an annual 3% cost of living adjustment, we get a different level of portfolio withdrawals. This COLA can be set by choosing the "Custom" inflation treatment and entering the annual adjustment.

This plan allows for $3280/month in portfolio withdrawals, which is somewhat lower than in the case of a fully inflation-adjusted pension and somewhat more than with a nominal pension.

The reason we see portfolio withdrawals that are lower than with the fully inflation-adjusted pension is that inflation may in fact be higher than 3% in the future or may at least go through periods where it is higher. The Income Lab app accounts for a range of inflation sequences and experiences. This plan still has some inflation risk - though less risk than it would have with no pension adjustments at all.

A pension with a higher annual COLA would allow for even higher portfolio withdrawals. Also, a plan with lower inflation assumptions (either the average expected annual rate or the standard deviation of inflation or both), you would also see higher withdrawals because the plan would be expecting lower inflation risk.