Inflation is simply the rising costs of goods and services over time. It’s an important part of the planning process to make assumptions about buying power over time. It allows you to know how to budget your money using a placeholder that should represent to some academic degree the effectiveness of your dollar as you get closer to the time you need it.
However, I have had several discussions with clients who assume the incline of inflation is something like 2% annually. And while that is a reasonable, and likely adequate initial placeholder, if your financial advisor is simply using that number because the talking heads on TV or the software they use have that number already baked in, then you need to have a serious discussion about the gaps that arise from such short cutting.
A miss on the inflation discussion has two permanent repercussions on your financial plan:
- Inflation assesses its toll further and further into plans. It’s insidious and you won’t know the impact until the end of retirement, when you have fewer resources to make course corrections.
- It will affect what your expectation should be for your internal rate of return, particularly in your fixed income investments. If you are assuming a 2% inflation rate a 2% treasury may be appropriate, but if your personal inflation rate is actually 4% (likely from the reasons below) you will have an unaccounted for gap between the rising costs of goods and services and the yield from your chosen investments.
This article is a good checklist to make sure that your financial advisor can discuss and will make adjustments for this gaps in inflation math:
No two retirees live the same lifestyle in retirement. If heard other advisors say that, and be able to adjust the product suite they use for risk, or which goals they bake into a plan, or even change the expected costs they use from goal to goal. But then each of them will extrapolate the costs of that lifestyle inflating at 2%. This is a mistake. This shows a lack of understanding as to what causes inflation and the effect it will have on your plan.
Inflation does not affect all products equally, in fact the most impacted items are usually isolated to the items that are purchased by everyone. Groceries, gasoline, and basic services are more impacted by steadily rising costs than that of large ticket consumer goods and electronics.
You may think that this isn’t a big deal right? We all buy groceries and that is a part of my financial plan. This type of thinking is ill-advised and offers a major gap in the calculations and the expectations you should have for your income.
A client of mine said:
“I have a simple life, I don’t buy that many new things, and I’m not all that interested owning new cars, clothes and gadgets in retirement, my calculation for inflation should be pretty low.”
So he wanted me to lower his expected rate of inflation. I said wait a minute, you’re not thinking about that correctly, while yes, he is right that the things he buys may be simple and he’s not going to buy much, he’s wrong about the effect of inflation. Because he’s using the “2% average” he’s heard about he’s missed where the number comes from. The CPI is the change in a basket of goods and services, so it takes into account everything a regular american can reasonably buy (and it doesn’t include gasoline). So in aggregate the number may be 2%, but by not buying those items he’s taking on more, not less, inflation risk for the normal person. See in the chart below where we have eliminated the baskets he didn’t see himself buying (recall that the higher ticket consumer goods generally are disinflationary – the cost of a flat screen TV comes down with time and not up).
|Item||Annual change in inflation as a Percentage(%)||Example clients inflation estimate|
So while he is thinking that his appetite for spending is low, his exposure to inflation is more than twice the normal of people in retirement. So when we plan we are trying to extrapolate the costs of a certain lifestyle in retirement, in this scenario the inflation expectation should rise for this client, not fall. More severely, using a standard 2% inflation rate, will cause him to have a shortfall that becomes more complicated as he gets deeper and deeper into retirement.
Declining quality is inflation
Several of the items that comprise your quality of life today, deteriorate in quality over time. This is not a hard and fast rule, and in some cases the opposite is true. But if you think about the nature of appliances, automobiles, and other big ticket consumer goods they can become suspect. The refresh cycle for large appliances in the 1990’s was 20% longer than it is for today. This is the result of a few elements, the “smart” revolution and added technology creating more demand for new items, and the decline in their quality. Both of these are measured as disinflationary, the costs of these items have come down year over year, and the “features-scape” is expanding. This all seems disinflationary and in the CPI it’s measured as costs coming down on these items. And while that might be a true statement for someone, the Bureau of Labor Statistics “buys” these items year over year to test the market changes, and for most people this is actually hidden inflation.
Here is the math. If the price of an item comes down year over year by say 4%, but the refresh cycle is impacted by anything greater than 4% in a year, the result for regular people is actually inflation, not deflation. Because the total cost of ALL of the units you will be required to buy over the 20 or 30 years of retirement is actually higher. This is the source of hidden inflation for anyone using the 2% inflation rate. Assuming that while the cost of a good from year one to year two has gone down or stayed flat, the frequency that is required to make the purchase has actually gone up. Thus the total cost of your retirement has actually gone up.
This source of hidden inflation does not affect all people the same. Those who are planning on purchasing items of quality or extend their expected refresh cycle on cars are less impacted by this kind of inflation then those who like to have their retirement include traveling in RV’s, owning boats, or managing rental properties that provide the appliances to renters. Knowing what your retirement will look like should impact the assumptions your planner is using.
Expanding scope is inflation
The easiest way to see the expansion of scope for retirees is in healthcare. And while having medical reserves earmarked for the rising costs of your current healthcare are likely in your financial plan, the expansion of what you might be treated for in the future may not be. Having insurance is one step for mitigating the costs for this expansion of services, but it doesn’t totally alleviate the rising costs of healthcare by an expansion of service. The number of ailments retirees are treated for is expanding with each generation.
But this form of retirement scope creep isn’t isolated to healthcare, and unfortunately, the other forms of inflation that come from an expansion of scope are not something there is insurance for. Retirees take on new hobbies, make new friends and see their family expand and grow in ways they didn’t budget for. A family that writes a financial plan when they are childless should revise that plan completely when they start having children. This is no different for retirees as their life and family changes, new goods and services they want to pay for as part of their plan will inevitably change. The retirees that planned for a pair of domestic vacations every year in retirement will see either those trips cut down or repurposed when their children move to different cities. This is inflation in the amount of goods and services you want to buy, in this case rental cars and plane tickets.
Seeing an expansion in the things people want to do in retirement is nothing new for planners, but using a simple 2% inflation number robs them of the nuance associated with those expectations. In this example the costs of plane tickets is the result of several underlying changes in the marketplace, costs of labor and fuel, and the distance these children move. Not understanding the effect these changes have on inflation means using the 2% benchmark will at some point force the retiree from making the decision between a Mexican beach and seeing a new grandchild be born. Drafting a plan that minimizes these sacrifices is the reason for planning in the first place.
Quality of life
The math behind calculating inflation is simple for a reason, to be as ubiquitous as possible. We can benchmark TIPS from this math, assess the future costs for planners, and determine the domestic strength or weakness of the dollar year over year. But one thing it cannot account for is the expansion of quality of life in retirement.
Simply put, this is the retirement costs that the normal people didn’t account for and that have become essential in retirement. I have a couple that when they initially retired in 2004 had a pair of cell phones, and a plan where they paid for a few minutes. But the change in their family, grandkids living out of state, and the desire to facetime with them has required that the things they buy and pay for were never accounted for in their 2004 plan.
The expansion of technology is largely the reason for this inflationary pressure. That new items in the goods and services we enjoy that in 2004 were a luxury, became essential expenses in 2020. This is much a discussion of planning for new things you’ll want in retirement, as is it a discussion on inflation. Because while discussing adding new purchases might be part of your existing plan, seeing those purchases move from a discretionary purchase to a fixed cost is a hidden source of inflation.
Seeing your lifestyle change or new technology and medical services that were never part of financial plans drafted even five years ago are having an outsized impact on the year over year cost expansion for those in retirement. This is affecting retirees at a fast clip as the world invents new products and services. They want to move these luxuries into our daily expectations, and this, at its core, is an expansion of the total number of goods and services we want for a certain quality of life. This is an inflation discussion and simply picking the 2% figure as an expectation your plan isn’t accounting for which leaves a lifestyle “gap” for you in the decades to come.
Relaying the effects of inflation into a financial plan is not an exact science, but simply using that same baseline 2% for every retirement plan is bad science. It’s giving up on the reason planners make plans. Your goal in financial planning should be to divide your goals and put reasonable math and strategies in place to achieve them. Using a baseline rate for inflation regardless of these goals and expectations is lazy planning and not worth the time or money you’re committing. Inflation affects everyone differently, but using a global benchmark in a personal plan is a mistake. So what can you do to improve your plan, and determine if the CFP® Professional you are working with is with it:
- Have a discussion with them on the weighted sources of inflation in your plan
- Agree to “personal inflation rate” as a result of your expectations that is not derived from the CPI benchmark
- Stress test your plan with the “personal inflation rate” and a high water mark inflation rate to confirm the solvency of your plan
- Fire the advisor that cannot or will not do this work