Financial Planning Blog

Posted on: 11/17/11

Thinking Clearly About Inflation

In planning for your financial future, accounting correctly for inflation is absolutely critical. Unfortunately, thinking clearly about the impact of inflation isn't something most people do naturally. Most of us have a tendency toward what behavioral economists call "money illusion", where we think about dollars in "nominal" terms, as opposed to their "real" or inflation-adjusted value. We routinely confuse the face (nominal) value of money for its purchasing (real) value.

Here is a quick example of money illusion. Nick gets a 3% raise during a year when inflation is at 3.8% (as in 2008). Nora gets only a 1% raise during a year when inflation was actually a bit negative, such as in 2009. Who got the better deal? Most people would say Nick, whose nominal raise was three times that of Nora's. However, the real purchasing power of Nora's salary increased over 1%, while Nick's actually declined almost 1%. Despite getting a smaller nominal raise, Nora actually got a much better deal than Nick--it probably didn't feel that way.

People are just not very good at factoring in inflation as they think about their money over time. Gary Belsky and Thomas Gilovich give a couple of reasons for this in Why Smart People Make Big Money Mistakes: "First, accounting for inflation involves the application of arithmetic, which is often annoying and downright impossible for many people. Second, inflation today, at least in the United States, is an incremental affair--2 percent to 4 percent, on average, over the last decade and a half...little numbers are easy to discount or ignore."

Although it might be somewhat difficult, and the impact may seem small, accurate thinking about inflation is crucial in avoiding some big financial planning mistakes. Here are three areas where people commonly fail to consider the impact of inflation on their future:

  • Projecting investments and salary forward at a nominal growth rate, but failing to adequately consider that expenses will also be going up with inflation. For example, a 50 year old couple anticipates having $2.5M saved by age 65, considering their current savings rate, anticipated raises, and portfolio growth of 7% per year. Assuming a safe 4% withdrawal rate, that means $100K of income in retirement, to be combined with Social Security of about $36K per year. Wow, that's considerably more money than they make today! Maybe they can cut back on the savings a bit, and enjoy life a bit more. What they don't understand that these anticipated investment returns factor in an expected inflation rate of about 3%. What costs $100 today will on average cost over $150 in fifteen years at that rate. With 50% higher expenses, that $2.5M nest egg doesn't seem quite so adequate.
  • Investing so conservatively, that a portfolio does not grow at a sufficient pace to offset inflation. Many people cannot bear the daily ups and downs of the stock market. Instead they choose an ultra conservative portfolio of CDs, money market and other fixed income investments that will provide a lower, but steady return. Even though the nominal return may be steadily positive, the real return of such a portfolio is anything but steady and positive. At its best the ultra conservative portfolio will barely outpace inflation. At its worst, this combination of investments will leave the investor with less and less purchasing power over time. As Larry Swedroe points out: "The lesson we take from the historical evidence is that those seeking to avoid investment risk may incur the even greater risk of the loss of their purchasing power over the long term. The bottom line is that in terms of achieving financial goals, the return from riskless instruments may likely to prove insufficient." The only ways a person can effectively compensate for the lack of real growth in their portfolio is to lower their expectations for the future, or save more--generally a lot more. Unfortunately, not many people are willing to do either of these.
  • Not understanding the significance of cost-of-living-adjustments (COLAs) on pensions, annuities, and Social Security. Imagine two friends retiring the same year from two different employers. Ed considers himself very lucky, and will get a $4,000 per month pension from a private sector employer. Like most private sector pension plans, Ed's pension does not include any inflation adjustments. His neighbor, Ralph will also be receiving a $4,000 per month pension from a public sector employer, and it will have annual COLA adjustments. In year one the two friends feel equally happy, have a similar lifestyle, and they enjoy the same purchasing power from their healthy pensions. However, after twenty years averaging just 3% inflation, Ralph will be receiving about $7,200 per month, but Ed will still be receiving $4,000. Those two pensions, which seemed so equal at the beginning, are anything but equal. A pension or annuity that does not have any provision for inflation adjustment is worth much less than one that does. If inflation is low, the difference will take a while to show up. However, just a few years of extremely high inflation, such as experienced in the 70's and early 80's, will wreak havoc on the fixed pension. The impact of inflation on a fixed pension should be anticipated from the start, but a lack of planning for the inevitable decline in purchasing power is a common mistake.

Social Security is an inflation adjusted pension or annuity that most Americans will benefit from in retirement. Discussions are underway about the right methodology for determining future Social Security COLAs, and these changes will likely result in somewhat lower future inflation adjustments. However, even with some tweaks to the calculation, people should continue to receive tremendous value in having a basic foundation of inflation adjusted retirement income through the system.

Of course, we don't know exactly what inflation rates will be in the future, but we hopefully know enough to plan. Investors need to realize that there is a certain level of inflation expectations implicitly or explicitly built into the prices of stocks, bonds, and other investments. It is important to always consider the difference between the nominal return to investments, and the real return. Higher nominal rates of return may sound better, but real rates of return will determine your future lifestyle. The big risk to our financial plans is if inflation rates deviate significantly (up or down) from the somewhat low inflation expectations built into current stock and bond prices. Protecting yourself from both expected and unexpected inflation is a key objective of portfolio construction.

In later posts we will look at the Consumer Price Index--some of the controversy around it, and why your personal inflation rate may look very different from the averages.


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