Any serious financial plan has dozens of inputs and significant variables that influence the projection of long-term financial security. At a high level, it’s easy to understand that your life expectancy, the value of your assets, your spending preferences and expected investment returns are all critical assumptions.
These are the key numbers that draw most people’s attention but can cause them to overlook another variable that can be more difficult to grasp. The choice of an inflation factor to represent growing cost of living over time, is more meaningful than many people think. Even adjusting inflation up or down just a half percent will have significant effect.
Imagine two sisters who each retire with $500,000 at age 65. Each expects to spend $25,000 from their savings in year one and then adjust spending each year for inflation. One sister has average cost-of-living increases of 2 percent, the other of 2.5 percent due to a different lifestyle and spending choices. Assuming they each live 25 years and earn a 6 percent annual investment return, the sister with the lower cost of living will have $84,000 more left in her account at the end of this period than the sister with the higher inflation drag on her money.
Over the past several years, sluggish economic growth and stagnant wages have led to historically low inflation. It may not be prudent to expect low inflation to persist for decades, but it also may not be necessary to use an inflation assumption equal to long-term averages either.
The Consumer Price Index (CPI) is a measure commonly used to track U.S. inflation. Since 1914, CPI inflation has averaged close to 3.3 percent per year. Since 2000, the average CPI has been 2.2 percent per year. But there have been 30-year periods where inflation has been below 1 percent and 20-year periods where inflation has actually been negative. Over rolling 20-year periods, inflation has been under 2 percent nearly a quarter of the time since 1914.
Given aging populations in much of the developed world and economic growth well under its long-term trend line, some people see no spark for meaningful inflation well into the future.
You only Spend in ‘Real’ Terms
After subtracting inflation’s effect, what you have left is the real growth of your income or investment balances that you can use to increase or maintain your standard of living. Particularly if investment returns for diversified portfolios are expected to be lower than historical precedent, the amount of investment return that is negated by inflation could be important. For instance, if you have a 6 percent average investment return and 1.5 percent inflation, you have 4.5 percent real growth. If inflation averages 3 percent, your real growth is cut by one third down to 3 percent per year. Many people don’t have enough margin of safety in their financial plans to have their after-inflation growth rate cut by a third and still cover their cost of living.
You might think that you can control your personal inflation, by keeping your spending lower than the average consumer and stretching your money. This is possible, if not entirely realistic, because there is a lot of difference in inflation from one person’s living standard and habits to another’s. But rising costs also strike people in areas that people have less control over, notably health care. Medical costs have risen at a faster rate than general spending, particularly for aging people who require more care, procedures and prescriptions.
No Consensus on What’s Right
In addition to evaluating past inflation trends as reported by the government, information is available from economists and investment market analysts who attempt to model future conditions and create forward capital market assumptions. Vanguard assumes a 50 percent likelihood over the next 10 years that inflation will be less than 1.8 percent per year. The investment professionals at Bank of New York Mellon predict a 2.5 percent inflation target while J.P. Morgan projects that inflation will average 2.25 percent. These numbers could be far different over the long run because inflation can spike in short terms and averages can present a flawed way to look at anything. Remember, a 6-foot-tall person can drown in a river that is 3 feet deep on average.
When we create financial plans for clients, we have settled on a 2.25 percent inflation assumption. It’s much easier to use this projection with confidence for someone who is 70 than it is for someone who is 50, however. If you do your own financial projections, use online calculators or reports from an adviser, pay as much attention to the inflation factor as any other critical variables that define your personal financial strength.
Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor. Reach him at firstname.lastname@example.org.
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