Reader-Submitted Question of the Day – Day 1

April 29, 2008

Over the next 11 business days, I’ll be posting reader-submitted questions of the day. This is my attempt to try to open up AFM to the readers and make it a little more interactive. Plus, it’s a great way for me to avoid having to come up with questions!

Today’s question comes to us from AFM reader and financial planner, Dylan Ross:

What do you think is an appropriate number to use for inflation for planning purposes? Professionally, I think 3% is a little to sunny to plan a future on.

That’s a good question. To my knowledge, the most widely-used inflation gauge is the Consumer Price Index (CPI). So, if we don’t use a 3% inflation rate for planning purposes, what number should we use? That’s a good question. I suppose we could use a range of 3% to 5% and plan accordingly. I think the important thing to focus on is long-term inflation, not the short-term spasms that occur from time to time.

What are your thoughts?

10 responses to Reader-Submitted Question of the Day – Day 1

  1. I agree with focusing on long-term inflation.

    This website gives some very good information on annual inflation. As you can see, long term regression line shows that inflation is in a downward trend, even with a 6 year up-trend. Based on this info, it seems that 3% is a good number as inflation is, for the most part, unpredictable.

  2. I still use 3 or 3.5% for myself and with clients. It is easy to get caught up in the moment with current trends, but as Tom pointed out, you really have to consider long term averages.

    Just like the stock market, history shows it averages a little over 10% a year. But if you look at any 5 year snapshot, you could see periods of strong negative returns or 20% or higher returns that at the time would skew your outlook.

    For much of the 60s, inflation was cruising under 2% for the most part, and then in the late 70s and around 1980, you were looking at double digit inflation numbers. So in just the span of a few decades, someone can experience a wide variety of inflation rates.

    So, I say stick with the data and don’t let short-term trends make you get too aggressive or conservative. In early 2002 when inflation was dropping to nearly 1%, were people thinking they should plan for 1 or 2 percent inflation rates in their retirement projections? No. So if inflation is now above 4%, that shouldn’t mean you suddenly have to adjust your numbers upwards either.

    It doesn’t hurt to use a slightly higher number to err on the conservative side, but I wouldn’t do it simply because of an 8 month trend.

  3. Personally, I think that is the wrong question. I think the correct question is, “What can I expect my after-tax investment returns to be?” It really doesn’t matter if inflation is 3% or 6% if your after-tax returns are 5% either way.


  4. Don said:

    “Personally, I think that is the wrong question. I think the correct question is, “What can I expect my after-tax investment returns to be?” It really doesn’t matter if inflation is 3% or 6% if your after-tax returns are 5% either way.”

    Inflation is what determines your real returns, which are returns adjusted for inflation. So, asking about inflation is a legitimate question.

  5. The problem with Inflation is that it can sneak up on you.. and before you know it, it’s 10%.

    The last time we had to deal with high inflation was in 1971-1983, when it peaked at 13.3%. I don’t think you can use 3% for long-term planning, because if we have 8-10% in the next few years, it would totally change the results of your long-term calculation. That’s the nature of inflation – it strews up investment calculations.

  6. JLP thanks for choosing my question.

    I’ll agree that inflation assumptions should be long term and not based on what has happened over the last year. After all, people plan for many decades from now. But I think 3% is based a little too heavily on recent years, and I’m not confident the last decade or two is necessarily predictive of future price increases. Much of the heavily relied upon US market statistical data used in financial planning today is based on the last 30 to 40 years, a time period with inflation measures averaging over 4.5%.

    More importantly, planning should allow for some wiggle room. If your favorite sports team is playing another team that averages 12 points per game, do you want them to play like the other team will only score 12 points or do you want them to play hard, not knowing if their opponents brought their “A” game. Planning strategies should be approached similarly. Your opponent is inflation (and longevity too), and you don’t know if they will play an average game or if they brought their “A” game. If you’re ahead at the half, you can lighten up a little and keep an eye on the scoreboard. But when you’re behind and the clock is ticking, you usually have to get more aggressive and take bigger risks or settle for less desirable results.

  7. I take the approach of trying to think thru how inflation will affect me, and my purchasing decisions in the future, and how I might adapt if my estimates turn out to be wrong.

    For example, if I anticipate owning my home outright vs. renting, then I should be somewhat hedged on housing costs. “Somewhat” because you can count on taxes, insurance, and upkeep expenses growing rapidly at least for the next few years. Now, if I have enough assets to somewhat self-insure (by raising deductibles for example), then I have some ways of mitigating insurance costs. Those are just a couple of examples.

    I also feel its worth thinking about how my assets will react to inflation. The current downturn aside, real assets should generally keep pace with overall inflation. In addition, if I’ll still be in the workforce over the next 10 years, and I expect my income to keep pace with inflation, then I’ll be able to increase my savings/investment to partly offset the effects of higher-than-expected inflation.

    Also, positioning one’s skills & education to be able to take on post-retirement work (consulting, etc.) in the event your calculations turn out to be less than accurate is a good “hedge” against unexpected inflation (or lower than expected real returns).

    It’s not an easy subject by any means and I am not an expert. These are just some of the ways I try to approach the subject.

  8. Here is more of a question than a comment. Has there been any studies to show a relationship between the inflation rate and investments returns (i.e., with a higher inflation rate, higher returns typically occur or vice versa)?

    I wonder how varying inflation rates (from year to year) would affect long-term returns similar to how varying rates of return (from year to year) can negatively impact average returns somewhat significantly.

    Does anyone know of any simulations out there that take into account varying yearly returns and varying yearly inflation rates? It would be much harder to do if there is a correlation between inflation rates and investment return, because you can’t simply pull either from independent gaussian distributions.

  9. I usually go closer to 4%. If I am wrong and it is lower, great, plenty to retire on. If trends continue as they have for the past 40 years inflation will be in the 4-4.5% range, not the 3-3.5% range.

    Partially in response to Steve, my own informal study shows that the lowest 40 year real return in recent history was in 1995 at 6.91%, when inflation had averaged 4.49% and market return averaged 11.4%.

    The best 40 year return was retiring in 1972, with a real return of 10.80%. Inflation had averaged 2.91% and market return was at 13.72%.

    So I guess the message is that both market return and inflation can vary greatly, so plan for the worst and hope for the best.

  10. I am a bit concerned about long term inflation. It seems that with the twin deficits, the currency will have to continue to devalue to keep paying the interest on the increasing number of treasuries.