Expense Inflation

[marytaz]

I'm trying to figure out expense inflation for my ER. I found a historical CPI. Should I just average the past 10 years? Is there a good percentage to go with? Or should I look at each item as a different percentage, i.e., rent 6%, food 4%?

 

[Dash man]

The last ten years would be a really bad idea since inflation has been so low. I just went through the financial planning process and our CFP used 3% as an average, which I believe is considered a historical average over a much longer period. We have enough leeway in our plan to absorb periods of higher inflation if it occurs. Our main concern is increased medical costs, food costs and property and income taxes. Everything else is discretionary.


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[youbet]

I'm trying to figure out expense inflation for my ER. I found a historical CPI. Should I just average the past 10 years? Is there a good percentage to go with? Or should I look at each item as a different percentage, i.e., rent 6%, food 4%?

It's hazardous to use "averages" for either market returns or inflation since it's extreme behavior in either of these that causes FIRE portfolio failure. I'd test my plan using inflation data from a high inflation period, such as the 80's, and if it passes that, you're good to go.

If you use "average" inflation data, you're saying that you're confident you won't retire into a period of higher than average inflation. And that would be a weak test of your plans IMHO.

FireCalc does the work of testing with data from the distribution tails for you. If you're not familiar with FireCalc, I'd suggest you spend some serious time with the tool. Use not only the normal output graphs and data but also the spreadsheets.

Good luck!

 

[2017ish]

It's hazardous to use "averages" for either market returns or inflation since it's extreme behavior in either of these that causes FIRE portfolio failure. I'd test my plan using inflation data from a high inflation period, such as the 80's, and if it passes that, you're good to go....
Good luck!

Or, safer still, use the 1970s. (1913-1919 is likely to not recur, but that would be true belt & suspenders planning.) Average Annual Inflation Rate by Decade

 

[scrabbler1]

For the purposes of including inflation, I split up my expenses into two categories: Medical and non-medical. I have found this works out very well because it is the medical side which has much higher and often less predictable inflation while the rest of my expenses as a group are much lower and not as variable.

 

[youbet]

Or, safer still, use the 1970s. (1913-1919 is likely to not recur, but that would be true belt & suspenders planning.) Average Annual Inflation Rate by Decade

Yes, the 70's would be fine. Or perhaps the late 70's + early 80's.

The real point is that it's important to stay away from averages that disguise the real problem numbers by diluting them with less extreme data. This is especially true for inflation numbers. There is never a recovery from inflation. Once general prices go up, they tend to stay up forever. With market returns, recessionary periods are offset by subsequent periods of recovery.

Retiring into a prolonged period of significant personal inflation is not a pretty picture financially for a new retiree.

 

[rodi]

I use higher rates of inflation for medical and college. I have 2 kids that are still pre-college, and college costs are going up much faster than other expenses and I need to make sure the 529s will cover a large enough portion.

 

[braumeister]

For the purposes of including inflation, I split up my expenses into two categories: Medical and non-medical. I have found this works out very well because it is the medical side which has much higher and often less predictable inflation while the rest of my expenses as a group are much lower and not as variable.

IIRC, Fidelity's planner uses 3.5% generally, but 7% for medical costs.

 

[dallas27]

I use 2.5% because the stated policy is under two percent and i choose to take the high side of a 1% range from a mean of 2%. Not better than a coin toss, but you gotta pick sumthin'


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[ejman]

Inflation for individuals that are FI/ER is difficult to predict because of the great deal of control we can have over many of our expenditures. Cost of living in ER is largely driven by lifestyle preferences and these are particular amenable to creative solutions when one is free of the having to go to work constraints.

My personal experience is that over 12+ years of ER (since Dec 2002). My overall $ expenditures have remained remarkably constant although my standard of living feels about the same. Buy about the same type of things, travel about as much, eat out as often etc. Perhaps an exception to this is the cost of medical care which is indeed on a crazy unsustainable path (although I just started medicare - we'll see how that goes)

 

[Animorph]

Lots of different answers. Using CPI is one. As has been said, a longer average of about 3% might be better than just the last 10 years. Many people on the forum seem to think their inflation will be much worse than that. At least one researcher says actual spending in retirement tends to be flat. Not exactly 0% inflation, but you spend less in real dollars. So you can get just about any answer you want.

I have been inflating our budget with the CPI for the last 12 years or so, zeroing out the 5.8% increase in 2007 or 2008. Our budget now has a lot of excess slack. We'll have to figure out how to spend more. However, we have had plenty of changes, from kids leaving to actually retiring, so it's hard to say we're totally OK with CPI or above or below it.

+1 to youbet, FIRECalc tests your portfolio with actual inflation numbers and investing gain numbers from the same year. It seems likely that there is some link between those two that simple averages won't capture.

 

[youbet]

It's interesting how our position in history impacts our concerns. Most here who have FIRE'd have done so in the past decade or so. (There are exceptions I know.) That has generally been a period of low inflation. But we had the Great Recession. I retired into that. Ouch! So we tend to fret falling market returns/values.

But picture a retiree walking out of work looking forward to a happy retirement primarily financed by a generous non-cola'd pension in 1974. Picture him/her by 1984! Ouch!

While I'm not particularly concerned about high inflation for my retirement given what's happened so far, I do think that the casual attitude about the possibility of high inflation might be to the detriment of folks planning to FIRE a number of years out.

 

[DEC-1982]

IIRC, Fidelity's planner uses 3.5% generally, but 7% for medical costs.

FIDO RIP (Retirement Income Planner) uses the following:

General Inflation Rate - 2.5%
Healthcare Inflation Rate - 7%

 

[Walt34]

But picture a retiree walking out of work looking forward to a happy retirement primarily financed by a generous non-cola'd pension in 1974. Picture him/her by 1984! Ouch!

You're right, it wasn't pretty. A guy at work had a brother with that issue. It wasn't long before he was back to work.

Wow, talk about having your bubble busted.

 

[rodi]

But picture a retiree walking out of work looking forward to a happy retirement primarily financed by a generous non-cola'd pension in 1974. Picture him/her by 1984! Ouch!

My grandparents retired in the late 60's... non COLA's pension. All was good until it wasn't. My grandmother, who'd been a homemaker, never in the workforce, took a job as a "shop girl" in her 60's. She worked part time for about 7 years... just enough to supplement their income till inflation abated some. My grandfather had a decent (but non-COLA) pension) as well as SS... but inflation ate it up.

 

[mpeirce]

In financial planning one needs to be aware of the military concept of fighting the last war.

It's certainly prudent to guard against everything bad that happened in the past, but if you only do that you end up with a magnificent Maginot Line.

It's conceivable that we revisit run away inflation, but I expect the next crisis will be something completely different that no one expects. That's why it'll be a crisis.

 

[Senator]

The historical rate of inflation is ~3%, although we are headed towards deflation now.

The more important inflation that you need to consider is the inflation of expenses as a result of expense creep. You will not be working and might feel the need to spend more. Especially if you going to FIRE with a minimal income.

 

[walkinwood]

What are you trying to achieve? Forecasting spending going forward?

If so, a 3% will be just as good as any other guess. I find it very hard to predict even next year's spend. In any case, your budget will be determined by your withdrawal rate + any other cash flow source (pensions, SS etc).

I created a lot of spreadsheets before ER too, and they did have value. But in hindsignt, that value was mainly emotional. There are just too many variables that are beyond my ability to forecast (2008-09 meltdown & subsequent recovery, changing likes/dislikes, PPACA). Even looking back, CPI doesn't account for the changes in our spending - even when taking the whole 7 years into account.

I now use one of those initial spreadsheets to see how we are doing compared to where I thought we'd be. It is quite entertaining.

I second what Senator says. Be aware of expense creep. I'll add : don't ER until you have a good buffer (discretionary spending budget).

 

[DEC-1982]

Talking about healthcare inflation specifically ....

I just read an article this morning in the Oct 10 issue of the The Economist.

(Subject Area) Health Spending
(Title) The pause before fast-forward
A new study suggests the current hiatus in spending will be temporary

Article summary in a nutshell
Between 2000 and 2009 real health spending per person grew at an annual rate of 4% on average across the 30 or so mainly rich OECD countries. Since 2009 the rate slackened to just 0.3% a year.
DEC-1982 note: REAL not nominal

The OECD projects an increase in average public health spending from 6% of GDP to 8% over the next two decades.

-

So FIDO's RIP healthcare inflation of 7% may well be on the mark.

The reason I emphasize this is when I put my numbers into FIDO RIP as fixed and discretionary costs and its 2.5% inflation, the planner said I should be OK. Then when I broke my costs down into a detailed budget, and the planning then took into account my healthcare cost with its 7% inflation, the plan said I had some chance of failure, causing me to readjust my spending plans.

Hopefully America will do something about this runaway cost, otherwise this will bankrupt Medicare before it breaks my budget.

 

[Car-Guy]

I've used 3% for many years for my overall average but I don't break things down into categories. If I did, I'd probably double medical cost increases. In the end, 3% has been working for me. YMMV

 

[Independent]

Let's list the reasons for making an inflation assumption:
1) I have a non-COLA'd pension
2) ??

I think the important assumption is the difference between investment returns and inflation. Historically, that has varied a lot.

In a planning worksheet, I'd rather assume 0% inflation, then enter my investment return as a "real" rate. If I had that pension, I would make an assumption about how fast it shrinks. Then my numbers make intuitive sense.

Note that if I own any TIPS, I've got a locked in differential (vs. the CPI). The 20 year yield today is about 1%.

 

[marytaz]

Wow, lots of well-informed people here! Thanks!

It's been a real exercise in learning for me...going from never retiring to possibly early retiring.

I appreciate all your help! Thanks!