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Calculate SWR if CPI is inaccurate?
Old 10-12-2007, 08:51 PM   #1
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Calculate SWR if CPI is inaccurate?

The difference between the reported CPI and our personal cost of living has increased recently. For example, our rates for electricity, gas, and water/sewer utilities have had double digit increases each year for the last 3 years. Food prices are rising rapidly. Foreign travel costs have jumped with the drop in the US dollar against foreign currencies. These things are significant parts of our budget. We spend very little on things which have become cheaper lately such as clothes or electronics.

I have been retired for 11 years and DW for 7 years. There are, and always will be, plenty of things that we are not doing and do not need to do but would enjoy if we could safely afford the extra spending.

I have my own calculations in the style of Firecalc since I need to model some things, like our small pensions with partial CPI adjustment, that Firecalc cannot handle. Both my calculations and Firecalc indicate that our spending is more conservative than necessary. However, both of these calculations use the CPI to adjust future spending, which seems like a head in the sand assumption.

Adding a yearly spending increase above the CPI to my calculations drastically effects portfolio survivability. For example increasing each year's spending by (CPI + 2.5%) has the same effect on success probability as cutting the initial portfolio value by 40%.

I hope that this is too pessimistic, but maybe not. In any case, the 2.5% figure was pulled out of thin air.

Does anybody have suggestions for determining what is a "safe" withdrawal rate when the CPI does not accurately reflect our cost of living?

ExHermit
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Old 10-12-2007, 09:15 PM   #2
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If you want to increase your withdrawal inflation factor, then the only "safe" answer is to grow a bigger nest egg. Probably not what you wanted to hear.

Or, do as I do, and add specific hedges to your portfolio for your specific spending pattern. For example, if you're exposed to foreign currency fluctuations, doesn't it make sense to have a larger exposure to foreign investments in your portfolio?
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Old 10-12-2007, 10:03 PM   #3
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Originally Posted by ExHermit View Post
Does anybody have suggestions for determining what is a "safe" withdrawal rate when the CPI does not accurately reflect our cost of living?

ExHermit
If you'd like to model a CPI + .xx% inflation rate just add as many .xx% to your portfolio's annual expense ratio in FIREcalc.

Cb
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Old 10-13-2007, 03:09 AM   #4
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Thanks for responding.

twaddle:
Clearly, larger portfolios support larger withdrawals no matter what is happening with inflation. I'm not so sure about choosing investments based on types of expenses. I eat a lot of yogurt, but I don't see that as a particular motivation to invest in yogurt producers or dairy farms. The relevant question for any potential investment is "how will this investment, in combination with my other investments, effect my expected return and risk?" Surely I should invest where I anticipate the highest return, consistent with the level of risk that I am willing to accept, regardless of how I anticipate spending the money.

Cb:
I don't think Firecalc's expense ratio will work for this purpose. The expense ratio deducts a fixed percentage of the portfolio balance each year, so the added expense grows or shrinks with the portfolio balance. Increasing the inflation rate for spending purposes, on the other hand, results in a compounding increase in spending each year. A simple example: if the inflation rate is a constant 3%, in 30 years it will cost $2.43 to buy what one dollar will buy today. If the true inflation rate is 2.5% higher, 5.5% total, you will need $4.98 to buy that dollar's worth of goods in 30 years.

As I said, I pretty much pulled the 2.5% figure out of thin air. So I have little confidence in this particular adjustment for an understated CPI. Also, some have argued that the CPI was more accurate until recently (until 1992 IIRC). If that is true, then the correction should only be added to historical inflation values after 1992. There may be some totally different approach that makes more sense.

Our decision to retire early (each retired at age 46) was made years ago. Things have gone well so far and I don't anticipate any problem maintaining our basic standard of living. The question is how much purely discretionary additional spending we can afford: Do we spend 6 weeks in France next spring or only one month? How often do we go out to eat? etc. The answer depends A LOT on the true future inflation rate.

While we could always cut back later if necessary, it is not nearly as much fun to cut back on things you have become used to as it is to add new luxuries. I would rather keep our spending to a sustainable level, and increase it slowly if all goes well, than over spend and have no choice but to cut back later. On the other hand, I have no shortage of ideas about fun things to do with money, and no desire to leave money unspent when we are both dead.

ExHermit
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Old 10-13-2007, 03:32 AM   #5
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I'm not so sure about choosing investments based on types of expenses. I eat a lot of yogurt, but I don't see that as a particular motivation to invest in yogurt producers or dairy farms. The relevant question for any potential investment is "how will this investment, in combination with my other investments, effect my expected return and risk?" Surely I should invest where I anticipate the highest return, consistent with the level of risk that I am willing to accept, regardless of how I anticipate spending the money.
So, an investment's return is only a function of some risk premium?

Earnings growth has nothing to do with it?

Currency exchange rates have nothing to do with it?

If 4% works as a SWR for US consumers owning US stocks, let's imagine it also works for foreign stocks owned by foreign consumers.

So, if you plan to spend $10,000 each year in France, you'll want about $250,000 worth of French investments, n'est pas?

Why wouldn't this work to inoculate you from the "inflation" effects you're seeing due to the falling US dollar?

Likewise, if you spend $10,000 per year on dairy products, why wouldn't a $250,000 investment in the dairy economy ensure that you can safely pay those dairy bills? It probably wouldn't boost your overall returns, but it would probably track your dairy inflation pretty well.

I'll grant you that I've never seen a study to support this idea, but it might be fun to test my hypothesis.

In any case, I know of no way to predict future inflation -- even personal inflation, so I'm not sure how else you would even approach the problem.
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Old 10-13-2007, 10:28 AM   #6
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Cb:
I don't think Firecalc's expense ratio will work for this purpose. The expense ratio deducts a fixed percentage of the portfolio balance each year, so the added expense grows or shrinks with the portfolio balance. Increasing the inflation rate for spending purposes, on the other hand, results in a compounding increase in spending each year. A simple example: if the inflation rate is a constant 3%, in 30 years it will cost $2.43 to buy what one dollar will buy today. If the true inflation rate is 2.5% higher, 5.5% total, you will need $4.98 to buy that dollar's worth of goods in 30 years.
Seems to me the extra money is gone forever either way, and the effect compounds.

Cb :confused:
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Old 10-13-2007, 10:54 AM   #7
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Seems to me the extra money is gone forever either way, and the effect compounds.

Cb :confused:
The expense ratio is a percentage applied to the portfolio balance. The CPI is a percentage that is applied to the portfolio withdrawal. If one follows the standard FIREcalc model of withdrawing 4% initially then adjusting the amount by the CPI every subsequent year, any relationship between the portfolio balance and the withdrawal amount can diverge rather quickly.

I thought there was an option in advanced FIREcalc to model inflation based on CPI plus x% or at least a constant inflation fact of x%. But I don't think that is really the OP's question.

My best response to the OP's question is to attempt to model your own personal inflation rate based on the past 10 years of increases, with adjustments made up or down based on any changes (like if you were paying college expenses in the past and you're not going to in the future). Other than that, it's the age old question of trying to have the check to the funeral home bounce, and there's no perfect answer to that.

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Old 10-13-2007, 11:01 AM   #8
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The expense ratio is a percentage applied to the portfolio balance. The CPI is a percentage that is applied to the portfolio withdrawal.

2Cor521
Oh...

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Old 10-13-2007, 11:50 AM   #9
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We had the same dilemma and have decided to increase CPI by 1.5% in our projections. Then the challenge we have is to live to that budget each year. As long as we do not exceed the budget we will remain whole.

We also use 9% for portfolio returns. So far we have been exceeding the returns and underspending the budget. The budget is because we have gotten creative in our spending in the first 5 years of retirement. And we expect the portfolio returns we achieved in that period to be exceptionally high.

Our current SWR is down to 3.5% not that that matters as it is the original that counts.
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Old 10-13-2007, 10:56 PM   #10
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To clarify my question a bit: It is not so much the rate of inflation that I am concerned with, it is the difference between the CPI and personal inflation rate. If we assume that the past is a guide to the future (a much discussed topic), then Firecalc-like computations provide a reasonable estimate of the probability of being able to maintain a given level of inflation adjusted spending for a given amount of time. The Firecalc methodology provides for adjusting spending to match the change in the CPI. If the CPI does not accurately reflect personal inflation this methodology results in an ever-decreasing standard of living, something I hope to avoid.

One of the main attractions of Firecalc is that it does not require made up or estimated numbers for investment return or inflation. The underlying model is based on actual historical facts. The only estimated number is how long the money must last. (For my own purposes, I don't pick a particular length of time. I use life expectancy tables from the Social Security website which are based on census, death certificate, and Medicare data. I run the calculations out until we would be 120 years old, but discount portfolio failures based on the probability that one of us is still alive in the year of failure. No arbitrary estimates required. The gory details are not relevant here.)

Inserting an arbitrary number (2.5% above CPI) greatly reduces my confidence in the Firecalc model. I don't know that 2.5% is really the correct number. Even if I could accurately compute my personal inflation rate for the last ten years I would still have my doubts. I don't think that the difference between CPI inflation and personal inflation is really a constant. Historically, the December to December CPI inflation rate has ranged -10.3 to +20.4. Even if 2.5% is the correct number for the last ten years, when CPI inflation was confined to the range 1.6% to 3.4%, will it remain the correct number in the event of deflation or double digit CPI inflation?

I may be looking for a warm fuzzy feeling where the reality is that great uncertainty is unavoidable. Quantum mechanics makes me uneasy too, but it seems to describe the way the world works.

ExHermit
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Old 10-13-2007, 11:13 PM   #11
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It's still not clear to me what you're looking for. The CPI is based on a set of weights applied to individual components. Everybody's individual set of weights differs depending on their own spending pattern. And, of course, nobody's spending pattern is constant. In my experience, lifestyle changes completely swamp any inflationary effects on my spending.

So, trying to predict your future cost of living increases seems impossible to me.

The market only cares about the CPI. It doesn't care about your personal rate of inflation. So, if you know you are dependent on some oddball expense that isn't in sync with the CPI, then hedge against the particular inflation factor that worries you.

Otherwise, try to live within your budget, and if things aren't working out, try to adapt.

Edit: the BLS has a lot of component-specific data here: Consumer Price Index Home Page

If you really want a fun project, create your own inflation index based on your personal set of weights, then run that inflation factor against the historical data, and see how it changes survivability.
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Old 10-13-2007, 11:24 PM   #12
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If you are worried about your standard of living dropping after many years in retirement, then you have no choice but to pad your retirement fund considerably. This means working longer and saving more, obviously sacrificing today for tomorrow.

It's a tough tradeoff.

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Old 10-14-2007, 09:53 AM   #13
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This is one of the topics that usually draws out the flamebaiters attempting to undermine any reasonable discourse on the topic. Lets see how it goes this time.

The CPI is a fine measure of inflation for urban workers who rent an apartment and dont pay for health care. If thats your profile, then the CPI should track your costs pretty well.

Where I think some people are going to get themselves in a deep sticky mess is if they plan for the CPI in their investment planning and they're not urban workers who rent and dont pay their own health care. There seems to be at least a portion of folks that feel that they can plan in this manner, invest in items returning a "real" return vs the CPI, and safely live their lifestyle going forward free of the effects of inflation.

As you've noted, and the BLS themselves explains when they say in detail that the CPI is not THE measure of inflation but A measure of inflation, the devil is in the details and everyones budget will be affected differently.

One way to look at this is to try to get a rough idea of your spending and inflationary pressures that apply to your intended lifestyle. The painful part is that I suspect most people would see that their budget adjusted for their real rate of inflation is incompatible with their portfolio size. If your actual costs inflate significantly due to health care, energy and housing costs at a rate of 4-5%, you'll probably come to the conclusion pretty quickly that you're not going to make 4%+4-5%+taxes as a regular rate of return year in and year out. If the CPI is running at 2% and your PRI is 4%, CPI indexed securities arent going to be much help either.

Seems to me that most people break into one of two categories: one has a huge portfolio and slogs on without much concern and the other "discovers" that their spending is outstripping their investment returns. The latter effect has been somewhat muted due to a 14 year bull market that was only briefly interrupted by a 2 year bear.

The latter group also changes their spending/shopping patterns, stops buying some items/services or changes their lifestyle dramatically to compensate. Unfortunately a lot of these aids are one or two iteration changes. You go from shopping at the local fancy market to costco to buying dented cans at the grocery outlet emporium. Not much room to go down from there unless you buy a packet of seeds and a shovel.

Perhaps we've also scratched into why older retirees spend less as they age. It might have less to do with not wanting to spend money anymore and more to do with things becoming more expensive than their social security adjustments are compensating for, and watching their nest egg shrink too fast. Anecdotally, my dad feels that after 12 years on SS that the buying power on his money has shrunk significantly. Increases in medicare seem to be overwhelming the SS CPI adjustments, and the rest of his costs are heavily in the food and energy sectors.

I'd suspect that ER's who reside in a low cost of living area and plan to live in an LBYM mode will be just fine. Those in high cost areas that want a full featured health plan, to travel, and indulge in other expensive hobbies that are thinking that 4%+cpi will do them fine...are in for a rude awakening when the current up-nearly-every-day market slows down for 5-10 years.

The short answer is to roughly figure your PRI's delta from the CPI. If your PRI is more than a percent or two higher than the CPI and you're squeaking by on a 4% SWR, you're not gonna make it long term. That level of spending is simply going to be higher than a reasonable portfolios returns. You need to work longer or take a highlighter to the budget.

"Hedging against your inflation items" can be done for a few items, but its pretty risky and not a strategy I'd recommend. You can buy commodities or energy funds or health care funds. You'll feel a bit displeased with those investments when someone comes up with an oil alternative energy product that doubles or triples production while costing half as much, or when the health care system gets nationalized and all the profit gets squeezed out of it. In other cases I just cant see any benefit. Milk costs have doubled around here but I dont see the stocks of the large conglomerates that own most of the dairy production going up very much.
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Old 10-14-2007, 10:01 AM   #14
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In Advanced Firecalc under the Options tab you can type in any amount you want for inflation. Did I miss anyone in the postings above pointing this out?
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Old 10-14-2007, 10:02 AM   #15
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Terrific post, CFB. Very nice synopsis of the issue and how people are dealing with it, and the possible result of that. Me, I'll stay adaptable - as a single guy with LBYM tendencies, I think I can make the needed adjustments to spending and therefore WR, year-to-year as I eyeball my nestegg. Perhaps the bull will continue or reappear after a short absence, and I'll be in tall cotton. But it is also possible that things will chill out in an extended down market, and I will be a bit more frugal than I had hoped. I am looking at it in the perspective that a bit of austerity sure did not harm my parent's generation or the one before them, so I am sure will get along just fine. If it comes down to 'selecting bargain brands instead of designer labels', or else continuing to stay harnessed to the yoke until a traditional retirement age, then I sure know where I come down, personally! Where is unclemick, my hero!
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Old 10-14-2007, 10:57 AM   #16
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"Hedging against your inflation items" can be done for a few items, but its pretty risky and not a strategy I'd recommend. Milk costs have doubled around here but I dont see the stocks of the large conglomerates that own most of the dairy production going up very much.
Buy a cow?
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Old 10-14-2007, 11:19 AM   #17
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Yeah but then you'd have to get into that whole milk discussion about washing and homogenizing and hormones and imports and why George Bush is somehow involved. Oh yes, and Hitler.
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Old 10-14-2007, 11:47 AM   #18
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Yeah but then you'd have to get into that whole milk discussion about washing and homogenizing and hormones and imports and why George Bush is somehow involved. Oh yes, and Hitler.
LOL!

And don't forget farm subsidies!

Seriously, if you are going to go that route you might as well do the "self-sufficiency" thing - growing your own food, living in a "green" energy efficient house with lots of solar power, water collection system, etc.

That would definitely help counteract the ravages of inflation, and it could be challenging and fun and provide some folks with a very enjoyable retirement "project".

If you have other priorities, the above sure sounds like w-o-r-k.

Audrey
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Old 10-14-2007, 01:16 PM   #19
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Seriously, if you are going to go that route you might as well do the "self-sufficiency" thing - growing your own food, living in a "green" energy efficient house with lots of solar power, water collection system, etc.

That would definitely help counteract the ravages of inflation, and it could be challenging and fun and provide some folks with a very enjoyable retirement "project".
Yup, the ultimate hedging strategy is to buy everything today that you'll need in the future.

So, get the farm, fill a LARGE tank of gas, go to med school, and you can mostly stop worrying about inflation.
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Old 10-14-2007, 03:05 PM   #20
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Welcome back CFB. I missed you. How is the house sale and move progressing?

PS Our fallback plan is to move to Mexico. We can cut our costs by 40%: 3.5x.6=2.1% SWR and still maintain our travel plans. We had some great results from a convertible debenture: paying 6.5% since 2004 and currently valued at a 51% premium over face value.
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