Inflation affect

[Dogtrack]

Been doing some retirement planning, and was playing around with a planner on Fidelity. The assumption they (Fidelity) make that surprised me most was the inflation affect. Even with a modest inflation assumption, they apparently are trying to tell us that a $60,000 a year life style today would cost nearly $100,000 a year in twenty years. It doesn't seem to me that enough attention is given this by most.

 

[donheff]

Been doing some retirement planning, and was playing around with a planner on Fidelity. The assumption they (Fidelity) make that surprised me most was the inflation affect. Even with a modest inflation assumption, they apparently are trying to tell us that a $60,000 a year life style today would cost nearly $100,000 a year in twenty years. It doesn't seem to me that enough attention is given this by most.

I think most of us would find a $100K prediction for twenty years out to be low. Inflation at 3% will more than double your dollars in that time frame.

 

[RunningBum]

FIRECALC and any decent retirement calculator factors in inflation. I think pretty much everyone here understands the inflation effect, and it's such a base component that maybe it's not talked about that much. There's also an assumption that over time your investments will beat inflation. So just like you'd hope your salary income increases to help with inflation over the years; once retired, your retirement income needs to go up as well. When people talk about pensions, they always note, or are asked, if it is COLA or not, and whether the COLA really corresonds well with real inflation.

Is there something you think we're missing, or are you talking about the general population?

 

[Gone4Good]

Inflation is bad stuff . . .

Spending		Spending
Today	Inflation	T + 20 yrs
60,000	1%	73,211
60,000	2%	89,157
60,000	3%	108,367
60,000	4%	131,467
60,000	5%	159,198
60,000	6%	192,428
60,000	7%	232,181
60,000	8%	279,657

 

[RunningBum]

I think most of us would find a $100K prediction for twenty years out to be low. Inflation at 3% will more than double your dollars in that time frame.

That's not right, the rule of 72 says 24 years, I think that's not quite exact but in the ball park.

 

[Dogtrack]

I think Fidelity was using 2 and a half percent assumption on future inflation, which struck me very conservative. You hear/read comments on how inflation will eat you up and how you need to 'fight' it, but until you really see/digest 'your' numbers you don't appreciate how real the problem is.

 

[ziggy29]

I think Fidelity was using 2 and a half percent assumption on future inflation, which struck me very conservative.

When it comes to financial planning, my definition of "conservative" is erring on the side of worse than expected assumptions -- such as higher inflation or lower rate of return. With conservative assumptions you minimize the chances of not "hitting your numbers." Of course, it could also lead to the numbers telling you to w*rk another year or two, so it's not without tradeoffs.

My "conservative estimate" assumes 4% inflation and about a 6-7% return on invested assets.

 

[Gone4Good]

Sure makes 30 yr TIPS look really nice, even if real yields aren't as great as they once were.

 

[ziggy29]

Sure makes 30 yr TIPS look really nice, even if real yields aren't as great as they once were.

I loaded up on individual TIPS in November 2008 -- some July '16s and some January '25s -- when they were priced at a real YTM of about 2.9%. Glad I did it.

 

[IndependentlyPoor]

Yep, if you have never looked at the results of 20 years of inflation, the numbers can be an eye-opener. Assuming a constant inflation rate is bad enough, but if you really want to scare your pants off, have a look at what might happen statistically.

I know that FireCalc probably does this much better than I can, but ya never really understand something until you work through it yourself, so I decided to run Monte Carlo simulations on the effect of 20 years of inflation on $60K expenses.

For 500 runs I got a mean of about $112K after 20 years and about a 1-in-12 chance that the future expenses will be more than $160K or less than $74K. The mean corresponds to about 3% constant inflation and the high end corresponds to about 5%. (Whew! At least these check with Gone4Good's table.)

I got the parameters for the simulation by looking at the Bureau of Labor Statistics CPI data since 1913.
ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt

I assumed normal distributions, which is a pretty rotten thing to do, but the simulation doesn't have to be terribly accurate to make the point. Twenty years is a long time and the range of outcomes that we might expect, given the 97 years of inflation data we have, is huge.

 

[Koolau]

Inflation can be subtle and sneak up on you. To see what can happen, I think back to the day I started w*rking. I got what I thought was a pretty decent salary 40 years ago. When I retired 36 years later, I was making 10 times as much as when I started and felt financially little better off - all due to inflation. One crude example of inflation: Gas in 1970 was $.30. Today, I'm paying over $3.00. The taxes on the gas I buy today are almost twice what I paid IN TOTAL for gas in 1970. Still, I struggle with the concept of inflation because it is so insidious. My guess is we will eventually return to the inflation of the late '70s, based on the deficit spending we are in today. No crystal ball, but it's government's best tool to make it's debt less burdensome. Inflate it away.

I don't have the answer, but my suggestion is to use every tool you have to prepare for inflation. I think it's coming - sooner rather than later. Just MHO, of course and YMMV.

 

[chinaco]

... The assumption they (Fidelity) make that surprised me most was the inflation affect. Even with a modest inflation assumption, they apparently are trying to tell us that a $60,000 a year life style today would cost nearly $100,000 a year in twenty years. It doesn't seem to me that enough attention is given this by most.

Most basic personal finance books (about retirement) point out the importance of not overlooking inflation. There is a name for it: Inflation Risk.

inflation risk Definition

 

[dex]

The assumption they (Fidelity) make that surprised me most was the inflation affect..

A couple of thoughts:
1. The inflation risk has two aspects - prices - the obvious one. The not so obvious one is taxes. All the old and new tax thresholds are not indexed for inflation. So as your income rises you will be bumpbed into higher tax brackets as you are trying to get more income to deal with inflation. Add to that the IRA withdrawal requirements and you might be hitting the 'rich' tax rates. So you can see how complicated trying to project out you income requirements can be.

2. Some of your income streams might be indexed for inflation e.g. social security. But even that doesn't really keep up with inflation since it lags the actual prices and how it is calculated.

In my net worth projections I am using a 3%/year inflation (sort of a NPV) rate since 2006.to 2040 to put my estimates in perspective.

 

[ziggy29]

2. Some of your income streams might be indexed for inflation e.g. social security. But even that doesn't really keep up with inflation since it lags the actual prices and how it is calculated.

And going to your point, while SS may be COLA'd according to the government's chosen definition of inflation, the income threshold at which it is taxed at higher and higher levels is not. So each time you get a COLA, all else being equal more of your SS will be subject to taxation.

These "stealth tax hikes" based on non-COLA'd income thresholds have been a problem going all the way back to the AMT.

 

[Gone4Good]

These "stealth tax hikes" based on non-COLA'd income thresholds have been a problem going all the way back to the AMT.

What income tax isn't indexed. I thought all of the brackets were? The AMT isn't but they explicitly exempt people every year to give that effect. Maybe some exemption phaseouts?

 

[ziggy29]

What income tax isn't indexed. I thought all of the brackets were? The AMT isn't but they explicitly exempt people every year to give that effect. Maybe some exemption phaseouts?

The amount of taxation subject to SS taxes is not indexed. Yes, the underlying brackets are indexed, but whether or not SS is taxed (and how much of it is taxed) is not inflation adjusted. The thresholds are fixed dollar amounts.

Right now, a single person does not pay taxes on SS benefits at all if their income is below $25,000. They pay tax on 50% of their benefits from $25,000 to $34,000. They pay tax on 85% of their benefits above $34,000.

These thresholds are not adjusted for inflation.

 

[MasterBlaster]

I think most of us would find a $100K prediction for twenty years out to be low. Inflation at 3% will more than double your dollars in that time frame.

Using the rule of 72 you'd need an inflation rate of around 3.5% to (halve) the value of your dollars in 20 years.

 

[audreyh1]

Been doing some retirement planning, and was playing around with a planner on Fidelity. The assumption they (Fidelity) make that surprised me most was the inflation affect. Even with a modest inflation assumption, they apparently are trying to tell us that a $60,000 a year life style today would cost nearly $100,000 a year in twenty years. It doesn't seem to me that enough attention is given this by most.

Just so you know, since you are a new poster:

The tools we use here (FIRECalc) and the various safe withdrawal methods folks discuss here for financing retirement definitely take inflation into account. It's the man bogeyman for early retirees (who hope to live off their investments for several decades).

Audrey

 

[walkinwood]

I just read your other thread. If you haven't already, please consider reading William Bernstein's Four Pillars of Investment. It will put your mind at ease about a few things.

 

[rescueme]

I think Fidelity was using 2 and a half percent assumption on future inflation, which struck me very conservative.

Today's rate on RIP is at 2.3% for general inflation for all items other than health care, which is currently at 7%.

Fidelity adjusts these inflation rates several times a year. I keep my annual reports. Here's what I have, going back to early 2007 (when I retired):

May, 2007 - 2.47% general; 7% medical
January, 2008 - 2.43% general; 7% medical
January, 2009 - 2.30% general; 7% medical
January, 2010 - 2.30% general; 7% medical

Of course, the inflation rate can be overridden if you want to be a bit more conserative. You can also reset the minimum 90% target success to a 95% rate if you really want to plan for the OMG situation ...

I've found that their inflation rates are close to (but not exact) to the following CPI-U data at:
http://inflationdata.com/inflation/Inflation_Rate/CurrentInflation.asp

In fact, RIP showed a positive inflation rate for all of 2009, which the "official" rate was negative (which most of us don't believe)...

 

[Gone4Good]

The amount of taxation subject to SS taxes is not indexed.

Gotcha.

That's one overlooked because I do not now, nor do I ever expect to, receive social security.