Planning for Inflation: An Uphill Battle

I recently spoke with Maryalene LaPonsie from U.S. News & World Report on how inflation impacts retiree investors’ portfolios. You can read the full article here:

Inflation is a hot topic of late. After several years of extraordinarily low inflation rates, wages appear to be increasing and prices of consumer goods are inching higher.  It has been easy to feel complacent about inflation in our low interest rate environment.  The broader financial markets, however, are taking notice and are reacting to every news scrap about rising prices.  If we are indeed on the verge of higher inflation rates, then it is a good time to re-evaluate long-term spending plans and make necessary adjustments.

As investment advisors and financial planners we have a responsibility to use prudent assumptions in the long-term financial plans we construct for our clients. One of the most important assumptions used in a financial plan for a retiree client is the rate of inflation; and it is critical in two respects.  First, and perhaps most obvious, is that the inflation rate drives projected spending over the client’s planning horizon.  If, for example, the plan assumes annual spending of $50,000 in the first year and a 3% inflation rate thereafter, by year 10 annual spending is up to $65,239 – a better than 30% increase over the starting number.  Second, the inflation rate helps determine what rate of return is needed to keep assets growing at a level that will provide a successful outcome over the planning horizon.  Having identified a required rate of return – assuming it is within reason – an advisor can then design an appropriate mix of asset classes and select investments to support the plan.

While we have experienced relatively low annual inflation in recent years, it is important not to get complacent. Analysts project 2018 inflation to hover somewhere in the 2% – 2.5% range, still quite low.  Historically, however, the rate of inflation has been much higher, in the range of 3.3%.  And that’s just an average.  Those of us who have been around a while can recall much higher inflation in the late 1970s and early 1980s.

One of the hard truths for retirees is that they spend more of their annual budget on health care services and prescription medicines. The historic rate of inflation for health care spending is a whopping 5.3% according to the Bureau of Labor Statistics.  Since all inflation is not created equally, it is important to tailor your inflation assumptions to the spending categories you use.  At a minimum, one should place health care spending into a separate category and apply an inflation rate of 5.3% or greater to the category.  Doing so will more accurately reflect the notion that health care costs escalate at a greater pace than typical household spending and will help build a better, more conservative plan for the future.

Ultimately, this begs the question: Do you want to do this work in retirement? We always recommend that individuals seek the assistance of a financial advisor especially entering retirement. You’ve worked hard to plan for retirement and those of us at Unified Trust want to help you get the most out of it.  You see, we believe that retirement isn’t the finish line, it’s the starting line.

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