Consequences of 1% increase in inflation

[Stanley]

All of the talk on other threads about conservative investing and inflation made me go back to Firecalc and look at what might happen to my success rate if the inflation rate was just 1% more a year - 4% versus 3%.

First, I ran Firecalc using the CPI index. Then, I changed the parameters to use first a 3% inflation rate and then a 4% inflation rate. I ran the simulation for a 35 year period. 50/50 asset allocation.

Using the historical CPI and the 3% inflation rate I had a 95% success rate. Very nice! When I changed the inflation rate to 4% the success rate dropped to 65%.

So, a 30% decrease in the success rate if inflation increases by just 1% a year!!

I realize we are all in different situations in regard to where our retirement income comes from, but I am wondering what others have found when the inflation rate is increased by 1% a year?

 

[Meadbh]

What was the asset allocation? Have you modeled the interaction of AA, inflation and success rate?

 

[FinanceDude]

I would use 4%. IMO, we are heading into a long period of inflation. The govt is doing their best to keep the inflation beast at bay, but they are running out of options. We will have to inflate our way out of the mess. That is not going to be pretty..........

 

[ziggy29]

Another thing (and I'm not sure how much the models can account for this) is that higher inflation can lead to higher interest rates, which can reduce stock and bond returns. It could also trigger another recession if it results in sufficiently increased interest costs on the national debt.

 

[walkinwood]

Going from a 3% to 4% is a 33% increase in the rate of inflation. That's a pretty huge jump to sustain for a 35 year period.

Another question to ask - does a big change in inflation like this invalidate all the other assumptions that Firecalc is making - ie. would our history have been the same if inflation was so much higher?

 

[NW-Bound]

Inflation is the most effective way to reward workers at the expense of savers, read retirees. As the young generation will be blaming boomers for the mess that we may find ourselves in, I do not think young workers will have much sympathy for geezers like us.

As I have children, my consolation is to hope that they will continue to be gainfully employed, even if that is at my expense of a shrinking stash. I will just have to leave them with less or none when I croak.

 

[karluk]

All of the talk on other threads about conservative investing and inflation made me go back to Firecalc and look at what might happen to my success rate if the inflation rate was just 1% more a year - 4% versus 3%.

First, I ran Firecalc using the CPI index. Then, I changed the parameters to use first a 3% inflation rate and then a 4% inflation rate. I ran the simulation for a 35 year period. 50/50 asset allocation.

Using the historical CPI and the 3% inflation rate I had a 95% success rate. Very nice! When I changed the inflation rate to 4% the success rate dropped to 65%.

So, a 30% decrease in the success rate if inflation increases by just 1% a year!!

I realize we are all in different situations in regard to where our retirement income comes from, but I am wondering what others have found when the inflation rate is increased by 1% a year?

I don't really think it should be surprising that a small but persistent increase in the long term inflation rate would wreak havoc with many retirement plans. Inflation is cumulative and compounds in the same exponential way that compound interest does. After 35 years of 4% inflation, prices would be about 3.95 times higher than they are today. With only 3% inflation, prices would be only 2.81 times higer after 35 years. So after 35 years and 4% inflation, your portfolio towards the end of your retirement would have to support spending equal to almost four times your current budget - much higher than the default Firecalc assumptions. That additional money needs to come from somewhere, and that understandably puts lots of pressure on a portfolio that perhaps wasn't designed for periods of high inflation.

On the other hand, I would be very cautious about reading too much into the Firecalc results without knowing exactly what assumptions it is making in its calculations. Even though it hasn't been true for a few years now, bonds typically offer a modest net yield over and above the inflation rate. If there really were to be several decades of 4% inflation, bonds could be expected to adjust accordingly and offer investors higher yields to compensate for inflation. Over the long term, higher bond yields might very well provide most or all of the extra income needed to support higher spending forced by price inflation.

 

[ziggy29]

Inflation is the most effective way to reward workers at the expense of savers, read retirees.

This is true when wages are keeping pace with inflation. Not true in an era where the job market is so bad that employers can (and do) give *zero* raises for many years. In such an environment a worker can be on even more of a "fixed income" than seniors, since at least seniors have their Social Security COLA'd, and possibly a pension as well.

When workers are not getting raises, inflation screws them as much as anyone.

 

[Stanley]

Further playing with FireCalc shows that reducing my expenses by 10% a year, moves me back to over a 90% success rate even with a 4% inflation rate.

Obviously, none of these calculators can predict the future, they just try to model the past. The idea that we can precisely predict success with numbers like 93.2% is nonsense. But, we do have an idea if we are in the retirement ballpark.

 

[nun]

Inflation is just one variable that could wreck your retirement. You need to have a Plan B if the real world starts to deviate from your projections. So you'd reduce costs and look for extra income. The silver lining to increasing inflation would be that after an initial price hit your bond funds would start producing more income

 

[imoldernu]

The Fed policy is supposed to keep inflation low, and the plan is to raise interest rates. the market seems to accept this.
The bigger question is how long will this be possible. The theory is that as more money enters the market, there will be a multiplier effect. Loan to banks, who have to, in turn loan that money out, creating the QE stimulus. The problem is that the banks do better by not adding risk, and using the QE dollars an an interest bearing asset.
The M2 Multiplier has been in a steady downturn ever since 2008, with a corresponding slowdown in money velocity. The M2 Money Stock Velocity...(Federal Reserve) is at the lowest level ever,
In other words, the banks earn more by treating the Fed Money as a Treasury Bill, than by loaning it out.
All of this wouldn't be important by itself, and the theory is that a recovering economy will eventually lift all boats. The only problem with this, is that the Fed pays interest on the reserve balance, and the results of increasing the reserve haven't been forthcoming. The monies that are being borrowed to increase the Reserve, are now only covering the interest.

The economy is thought to be able to withstand a moderate 2% to 5% inflation.

Much attention is being given to the international balance of the monetary systems... currently focused on the EU, and especially Spain and Italy. China is a big Question mark, as they are more tightly involved in the money multiplier effect... at a rate double that of the US... an unknown factor at this point.
The "full faith and trust" of the US government has sustained the current valuation of US economy. The question is whether this can be maintained, and the worst worry would be hyperinflation.

Most of this is not left for us mortals to comprehend.

 

[brewer12345]

It ain't that hard to hedge against inflation, though. Add some commodities exposure (either via a commodities futures fund, physical stuff or commodity-driven equities), TIPS, I bonds, etc. You could alos take a 30 year fixed mortgage and put some or all of the proceeds into short term fixed income, commodities, inflation-linked bonds, etc.

 

[traineeinvestor]

It ain't that hard to hedge against inflation, though. Add some commodities exposure (either via a commodities futures fund, physical stuff or commodity-driven equities), TIPS, I bonds, etc. You could alos take a 30 year fixed mortgage and put some or all of the proceeds into short term fixed income, commodities, inflation-linked bonds, etc.

While I mostly agree with this, I am not sure if it is is quite that easy:

1. starting valuations may matter - if the price you pay is high to begin with, the inflation benefit may not eventuate. I query whether the prices of at least some commodities are already "high" and may not get as much of a lift from inflation as we might think. When inflation kicked off in the early 1970s, gold did exceptionally well at least in part becuase it started from a very low base (due to the gold standard). While I certainly do not know, I have reservations about whether it would be likely to do as well if inflation accelerated starting from today's price level? Equities performed horribly in the 1970s at least in part because starting valuations (Nifty Fifty) were so high.

2. whether the inflation is demand led - if the inflation is led by (or at least accompanied by) a rise in demand for various commodities, goods and services, the I would expect risk assets to do reasonably well. If we get inflation without growth (or insufficient growth) - stagflation - commodity driven equities may suffer as their production costs rise faster than the prices for the commodities that they produce.

3. this is not directed at TIPS, but some care needs to be taken with at least some securities which purport to be inflation linked. The ones issued by the HK government guarantee that you will get less than inflation (so long as inflation is above 1%) - there is no adjustment to the principal, payments of interest are made some time after inflation for the relevant period has been calculated and there will be a lag when getting your principal back. There is also the question of whether the CPI index matches the inflation rate you personally are experiencing - YMMV

FWIW, my retirement plan A assumes 4% average annual inflation (inflation has historically been a bit higher here than in the US) and have put most of my assets into equities and real estate - the theory being that even though rising interest rates may cause some short term pain, over a long enough time period I expect (hope?) that the income from the risk assets will rise to at least partly offset the impact of inflation. I'm also not making early repayments on our mortgages - even though they are floating rate, the interest rate is currently below the rate of inflation. As long as that remains the case and the rents exceed the mortgage payments and other outgoings, I see no need to accelerate the repayments.

Plan B is to have over budgeted our expenses by 20% from the start. Hoepfully this will give us enough of a cushion.

FIRE: exactly 200 days to go.

 

[audreyh1]

It ain't that hard to hedge against inflation, though. Add some commodities exposure (either via a commodities futures fund, physical stuff or commodity-driven equities), TIPS, I bonds, etc. You could alos take a 30 year fixed mortgage and put some or all of the proceeds into short term fixed income, commodities, inflation-linked bonds, etc.

I keep looking at when to add the Fidelity Strategic Real Return fund to my bond allocation, and the answer keeps being: well, not yet.

 

[brewer12345]

Well, if you can't or don't want to hedge, don't. I would not go overboard with inflation hedging, but I am happy to layer some into my own portfolio when I find reasonably priced opportunities to do so, So I have been buying some WIW, which is a pile of TIPS selling at a 10% discount, I buy I bonds every year, and I have been buying some commodity producers (mostly energy) since they are cheap and will do well in a demand-lead inflation surge. I also refinanced my 5 year ARM into a 30 year fixed mortgage.

 

[ERhoosier]

This analysis of future cost of living is prob much less precise than most appreciate. "Inflation" is a very general term, and specific methodology for gov't stats of "inflation" have changed over the decades. This makes long-term projections even more imprecise. And even US Govt concedes that CPI does NOT reflect actual cost of living for most US citizens/families. Especially since it does not include income taxes
Consumer Price Index (CPI)
Bottom line is future "inflation" is prob a larger uncertainty than most FP's appreciate- or at least dare to admit. IMHO- Everyone (ER or not) should plan on adjusting their actual spending somewhat as economic conditions change over coming years.

 

[DesiGirl]

Spare a moment for people trying to retire in countries like India where inflation is 6-12%. No real solution but here are a few tricks I'm using -* Like somebody else mentioned , higher exposure to hard assets like real-estate, gold, commodities etc. .* Calculate your personal inflation (Will be different than govt. numbers) and limit it to certain level, I won't be taking >8% adjustment no matter what.* Get used to substitution and lifestyle slide.* Creating a stream of inflation adjusted income (Rental & part time work) would be helpful.-DesiGirl

 

[obgyn65]

Yes. I have seen the devastating effect of long term inflation in my Excel model also. This is one of the reasons why I was planning to FIRE last year and decided to work a bit longer. When inflation increases by 1% per year I can still FIRE, however 4% per year over my 47-year time horizon is an issue. I may have to work some part time hours or spend a bit less during the first couple of years of FIRE, which is fine since I have always been frugal anyway.

So, a 30% decrease in the success rate if inflation increases by just 1% a year!!

I realize we are all in different situations in regard to where our retirement income comes from, but I am wondering what others have found when the inflation rate is increased by 1% a year?

 

[Stanley]

Bottom line is future "inflation" is prob a larger uncertainty than most FP's appreciate- or at least dare to admit. IMHO- Everyone (ER or not) should plan on adjusting their actual spending somewhat as economic conditions change over coming years.

+1

 

[audreyh1]

Well, if you can't or don't want to hedge, don't. I would not go overboard with inflation hedging, but I am happy to layer some into my own portfolio when I find reasonably priced opportunities to do so, So I have been buying some WIW, which is a pile of TIPS selling at a 10% discount, I buy I bonds every year, and I have been buying some commodity producers (mostly energy) since they are cheap and will do well in a demand-lead inflation surge. I also refinanced my 5 year ARM into a 30 year fixed mortgage.

I am still considering it - just not in a hurry to make that AA change as I tend to believe inflation will continue to be tame in the near future.

 

[Tyro]

Going from a 3% to 4% is a 33% increase in the rate of inflation. That's a pretty huge jump to sustain for a 35 year period.

Another question to ask - does a big change in inflation like this invalidate all the other assumptions that Firecalc is making - ie. would our history have been the same if inflation was so much higher?

Since FireCalc uses historical data to prognosticate future returns, it seems (to me) only logical to do the same with inflation, so I've been using 3.25%, based on: Decade Inflation Chart

Studying the chart a bit, I do wonder about the likelihood of our seeing inflation as high as that seen in the 191*s, or negative (as in the '20s & '30s), through the next 35-40 years(?) given the Fed's ability/tools to influence interest rates.

Tyro