Saturday, December 04, 2010

Stress testing for inflation (1)

When I retire, my expectation is that my cost of living will continue to increase due to inflation. Since I won't have employment related income, I need to be very confident that the private portfolio will continue to support our lifestyle over a lengthy time period. The point can be easily illustrated by using a spreadsheet (even for the semi-numerate such as myself) or one of the many calculators available on the internet. I used Firecalc at Early Retirement to illustrate the point.

If I plug in our current net assets, projected retirement budget, a 50 year retirement period and exclude the value of our home, Firecalc gives me the following results:

1. inflation at 3.7% pa or less: 100% success rate

2. inflation at 4.0% pa: 97.8% success rate

3. inflation at 5.0% pa: 75.6% success rate

The success rate falls very quickly as inflation climbs above 5% pa.

I also made an adjustment to reflect the fact that Firecalc assumes very low cost mutual funds as the investment vehicle of choice. Those funds are difficult to access from Hong Kong.

Even accepting that the calculator is using an average rate and that 3.7% is above the US CPI, these results do not give me the necessary level of comfort - CPI is not a satisfactory basis for estimating future cost of living increases. History tells us very clearly that extended periods of high inflation do happen and their impact can be devastating - the impact of the high inflation 1970s and early 1980s was an awful time to be relying on fixed incomes.

In any case, this is one of the reasons why I am still working (there are others).

There are a number of ways to gain the necessary level of comfort which I have written about before and will revisit in a future post.

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