Sunday, March 02, 2008

Inflation assumption critical to retirement planning

Inflation has significant implications for retirement planning. If we define inflation as the rate of increase in the cost of living, then it is fairly obvious that we need to allow for inflation in future living costs when we save and invest for our retirement. The longer the time horizon the greater the effects of inflation.

Inflation is like compound interest working against you

Through much of the last 10-15 years people have been generally unconcerned about inflation - after all the official inflation rate (known as the consumer price index (CPI)) was running at around 2% or so a year. This was often misleadingly described as "benign". But even at 2% pa, over a working career of 30+ years and a retirement of similar duration, any annual increases in the cost of living will have a significant effect. Look at it this way - long term inflation is like compound interest working against you.

Inflation is rising

The last few years have seen a material increase in the rate of inflation and a growing awareness that the CPI number is an unreliable measure of the cost of living. Accurately guessing the rate at which your living expenses will increase in the future is now a more critical component of retirement planning than it has been for some time.

Worked example - 3% v 4% inflation rate

Consider the difference between rates of inflation of 3% pa and 4% pa over a lifetime of working and a lengthy retirement.

Using this calculator I took as an example a 30 year old person who starts with a salary of US$80,000 and savings of $50,000 and who wishes to retire at age 60 with replacement of 80% of pre-retirement income. Rates of return both before and after retirement of 8% pa have been assumed and social security has been disregarded.

If the inflation rate is set at 3% pa, our future retiree needs to save 17.5 % of his or her annual income to achieve the desired level of income in retirement.

What happens if the inflation rate is raised to 4% pa? The required savings rate increases to a staggering 26% of annual income.

Conclusion

This shows just how vital it is to get the inflation assumption correct at the beginning of a savings plan. If you want to understand just how damaging delaying savings can be, try running a spreadsheet where you start with a savings rate based on 3% pa inflation and realise 5 years later that inflation has actually been running at 4% pa. The amount of extra savings needed to "catch up" with the resulting shortfall is quite sobering.

The blunt message is that not only does inflation matter but the assumptions you make about the rate of inflation in your personal cost of living over the course of your working life and your retirement are critical. A person who underestimates the long term effects of inflation runs the risk of living on a diet of cat food in his or her old age (or not being able to retire at all).

Note: doing your own spreadsheet and playing with different assumptions and other input variables is a good way of learning how sensitive your retirement plans are to changes in those variables.

7 comments:

Anonymous said...

Greetings from Singapore!

You should check out the retirement calculators from hell as listed at:

http://www.efficientfrontier.com/faqs.htm

traineeinvestor said...

Hi

Thanks for the link - those were quite interesting and a little bit depressing.

I actually run my own spreadsheet for longer term retirement planning which allows for some lump sums and reductions in expenses once the children finish university etc. The on-line calculators are useful but have their limitations. That said, my maths isn't up to doing monte carlo simulations, so I stress test by assuming a couple of years of negative returns during the first two years of retirement. Given my retirement income will be largely derived from rents and dividends, the risk levels are much lower, but who knows?

Cheers
traineeinvestor

Anonymous said...

traineeinvestor,

Greetings from Singapore!

You can try monte carlo simulation for retirement planning at:

http://www.moneychimp.com/articles/volatility/montecarlo.htm
http://www.flexibleretirementplanner.com/

Monte Carlo simulation for retirement planning seem to be popular - also check this recent article re: retirement planning at:

http://www.wilfredling.com/content/view/301/31/

Also, I suggest listen through presentation at:

http://www.aaii.com/audio/

Download the presentation from http://www.aaii.com/programs/conference/presentations/MCS_Retirement%20Spending.pdf so that you can listen through 75 minute of presentation - it is a very good presentation.

It explains very clearly why restricting your annual retirement spending to 4 to 5% of your total portfolio at the time of start of retirement has good chance of your retirement nest lasting through your life....

Enjoy!

Hope this helps.

traineeinvestor said...

Hi

Thanks for the links. Those were useful.

They certainly confirm that inflation does matter. The higher the inflation assumption the better than the more aggressive portfolio allocations perform against the more risk averse allocations (which is not a surprise).

Cheers
traineeinvestor

Wendy said...

Hello,

I am VERY new to all this and am trying to run some basic numbers. (Let me also add that math was never a strength of mine!) How does one "choose" the inflation rate to work with? Presumably we don't really know what it will be, correct? Are 3 or 4 percent common numbers to use? Thanks for your blog, I find it helpful.

traineeinvestor said...

Hi Wendy

Thanks for visiting.

There is no "right" answer to the inflation assumption. Most people use either a round number like 3% (quite common in financial planning and on line calculators) or use economists forecasts of the rate of change in the Consumer Price Index for the next year or so. It's as much guess work as science.

If you live in a high inflation country (e.g. China) then a 3% or 4% assumption for inflation is way too low. So do make sure that the assumption is realistic for your location.

Also, it pays to remember that it is your personal rate of increase in spending that matters. If your own spending is rising at a faster rate than the rest of the economy then you may need to adjust upwards.

Lastly, do not worry about not getting it exactly right. It is a prediction or assumption regarding the future. Not even Nostrodamus could predict the future with any degree of accuracy and we should have no reason to believe that we can do any better.

Cheers
traineeinvestor

Mango Kurry said...

I enjoyed reading your blog. My question is how does one assume an inflation forecast.