Does your financial plan account for inflation? Use this chart to see how inflation erosion can affect your savings.
No matter how costly, no financial plan can account for every possibility. After all, you may live to 120 or only a few years past retirement. Social Security could find a hidden windfall in Uncle Sam’s (deep) couch cushions, allowing a massive boost to your benefits. You could hit the Lotto or the Lotto could hit you, if a parade float runs you over. You could discover a priceless, gem-laden meteor! Or the world could be struck by one, ending life as we know it. Those are all possibilities, but they aren’t worth planning for—too improbable! That being said, a quality financial plan accompanied by sound management can help you manage your probable financial future—and risks to it. One such way: Accounting for inflation properly.
Inflation, a general increase in prices reducing the purchasing power of a dollar, is an insidious tax that especially targets retirees. Effectively, this means a dollar today won’t buy a dollar’s worth of goods and services years down the line. If you want to maintain the purchasing power of your retirement income, you’ll need to at least match, if not outpace, inflation. Too many folks without a proper financial plan fail to account for its impact.
US inflation is measured using a variety of gauges, including the Bureau of Labor Statistics’ Consumer Price Index (CPI) and Producer Price Index (PPI), the Bureau of Economic Analysis’ Personal Consumption Expenditures Price Index, and several other private-sector gauges like MIT’s Billion Prices Project. CPI is the most commonly cited and, since 1948-2016, the median CPI inflation rate was 2.9% per year. (US Bureau of Labor Statistics)
Maybe that seems small, but even such small increases can build up over time. Exhibit 1 shows the declining purchasing power of $10,000 under a 2.9% annual inflation rate.
Exhibit 1: Inflation’s Erosion—Hypothetical Impact of 2.9% Annual Inflation
Source: Federal Reserve Bank of St. Louis, author’s calculations, as of 12/21/2016.
But this is merely a measure of median inflation over time. Averages—means or medians—don’t predict, because they result from a large number of observations above and below the figure. You can’t simply extrapolate 2.9% forward ad infinitum.
Why Your Personal Cost of Living Doesn't Match CPI
More importantly, many Americans report inflation statistics are disconnected from their actual experience, claiming inflation is higher. And that is likely true. Now, we aren’t claiming inflation statistics underreport actual price changes. Rather, we’re pointing out the fact CPI (and other price gauges) are not cost-of-living measures. They measure inflation as a broad economic phenomenon across a basket of goods and services with predefined weights that may bear little resemblance to your expenses.
Exhibit 2 shows the CPI basket weights in broad categories. Consider how this matches your expenses. Then, think back to whether it aligned with your expenses in prior years—were you spending more eating out in your 20s? On education? If/when you had kids, how did your expenses change? If you moved from one city to another, what happened to your expenses? Imagine if you moved from, say, rural Georgia to San Francisco. What do you think would happen to your housing costs? CPI doesn’t and can’t capture those nuances. Your personal rate of inflation could deviate dramatically from the rates published in CPI.
Exhibit 2: CPI Basket Weights
Source: US Bureau of Labor Statistics, as of 12/21/2016. CPI basket weights as of December 2015.
If you, like some retirees, own your home outright, there is virtually no way you are experiencing anything resembling average or median inflation. The 42% housing weight isn’t solely the cost for the structure you reside in (it includes utilities and such), but that is a big part of it. However, many retirees have bigger than average exposure to very fast-rising prices, like medical care and education. Yes, education—as many help children and/or grandkids pay for higher education.
Your financial plan must account for prices’ changing nature—and your expenses’ changing nature, too. A financial plan that accounts for only one of the two, or neither, is missing a very probable risk that could endanger your financial future and the retirement you hope for. From an investing standpoint, retirees are likely to need more growth than they may think. Your financial plan shouldn’t hinge on worries about negative possibilities—World War III, a dollar collapse or the US defaulting on its debt. It should prepare you for probabilities—good and bad, like inflation and the high likelihood you’ll need more medical care as you age. We find all too many folks invest more with an eye on feared possibilities than the future they are much more likely to get.