Can You Help Me to Understand the Impact of Inflation on FIRECalc results?

[nico08]

Can You Help Me to Understand the Impact of Inflation on FIRECalc results?

Ok, so I have done a few runs using FIRECalc and used the Investigate function to see how much I would need in my investment portfolio today in order to achieve my retirement income goal with a certain degree of confidence.

When I use the FIRECalc CPI default choice for inflation, FIRECalc tells me I would need approximately $1,253,775 in my investment portfolio in order to have the retirement income I am seeking with 95% confidence.

When I use 3 percent as the rate of inflation, FIRECalc tells me I would need approximately $1,475,936 in my investment portfolio in order to have the retirement income I am seeking with 95% confidence.

So I found a chart that includes the annual historical rate of US inflation for the years 1914-2013. Since my retirement plan is based off of a 50 year time period, I used the data for the 50 year time period between 1964 and 2013. The average rate of inflation during this period was 4.18 percent. When I use 4.18 percent as the rate of inflation, FIRECalc tells me I would need approximately $1,837,043 in order to have the retirement income that I am seeking with 95% confidence.

I kept all other variables constant, the only one I altered was th rate of inflation.

Why do I get such a large difference between the required portfolio starting value using the FIRECalc default CPI rate when compared to the results I get when using CPI data that I acquired for the 50 year period between 1964 and 2013? Why do I get such a large difference between the required portfolio value using the default CPI rate when compared to the result I get using 3 percent as the rate of inflation.

As you con see, the starting portfolio value requirements are quite different depending of the percent used for inflation. I want to make sure I have thoroughly considered this issue before I pull any retirement trigger.

Any insight?



So I found

 

[ERD50]

Can You Help Me to Understand the Impact of Inflation on FIRECalc results?

.... When I use the FIRECalc CPI default choice for inflation, ....

When I use 3 percent as the rate of inflation, ...

I think I can help. Don't do that (the bolded part)!

If you 'choose' the inflation rate, you are completely out of the historical analysis mode, and into Monte-Carlo mode. So the report has nothing to do with 1964-2013, it is using some randomization for returns, or your chosen rate of return.

If you are selecting:

A portfolio with random performance, with a mean total portfolio return of...

or

A portfolio with consistent annual market growth of...

You are out of the historical analysis mode. Others may disagree, but I see little/no value in this mode, and prefer to see how my portfolio would have returned with everything that history has thrown at us - which includes some long periods of high inflation.

Select " Total market, split between equities and fixed income. Include performance since .... "


-ERD50

 

[nico08]

Hi ERD50:

Thank you for the feedback and I understand what you are saying. But how do I account for the marked difference in success results between FIRECalc's historically generated CPI numbers and the historical CPI numbers that I utilized, tracking a sequence of fifty years?

Is there anyway to see the actually CPI data that FIRECalc is using? Do you know where it was pulled from, what the source of the data is?

 

[ERD50]

I think it just uses publicly available CPI data, a search should turn it up (check the BLS and .gov sites).

You could try the spreadsheet option, I believe that shows the CPI factors for a specific starting year, but it only works for 30 year periods IIRC.

Otherwise, it is outputting data combined from all the X-year scenarios, so I don't see any way to pick it out.

-ERD50

 

[nico08]

Thanks ERD50. I realized the inflation rate variable was important, I just did not appreciate what a dramatic difference it could create, in terms of my required starting investment portfolio value, depending on whether the predicted inflation rate was slightly lower or slightly higher.

 

[jerome len]

Inflation is a fact of life.....some of us can remember the 20% interest rates of 35 years ago that caused a spike in inflation resulting in the 4% annual rate over the past 50 years.

No one can look ahead with certainty but we can invest to protect ourselves. you can buy dividend mutual funds.....most increase dividends at a rate higher than inflation. SS increase with inflation and there are bonds that increase based on increases in inflation.

For me, I'm heavy in dividend stocks, mutual funds and a ladder of municipal bonds. Also, I don't think I'll want to spend quite as much after I reach later life......so I will probably cut spending for travel like my parents did. I'd just let firecalc do their job, know whatever you use is just an estimate and enjoy your good health and stash.

 

[ejman]

If you really want to get depressed, see what inflation rates like Brazil or Argentina (10% plus compounded per year) will do. Basically, there is no rational investment allocation that can survive that sort of attack and even extremely large starting NW balances will just shrivel and die.

 

[nico08]

Wow- that is rather depressing

 

[nico08]

Inflation is a fact of life.....some of us can remember the 20% interest rates of 35 years ago that caused a spike in inflation resulting in the 4% annual rate over the past 50 years.

No one can look ahead with certainty but we can invest to protect ourselves. you can buy dividend mutual funds.....most increase dividends at a rate higher than inflation. SS increase with inflation and there are bonds that increase based on increases in inflation.

For me, I'm heavy in dividend stocks, mutual funds and a ladder of municipal bonds. Also, I don't think I'll want to spend quite as much after I reach later life......so I will probably cut spending for travel like my parents did. I'd just let firecalc do their job, know whatever you use is just an estimate and enjoy your good health and stash.

Hi Jerome Len:

It sounds like you have a good perspective on preparing for early retirement. Thank you for your insight.

 

[Animorph]

When you change the inflation number does the number of failures change by just one or two? You may be changing just a couple of bad scenarios. Particularly during something like the Great Depression you're probably changing deflation to inflation and making it even worse. Any period with low investment returns but low inflation would be at risk if you just blindly set inflation to 3%. Much better to stick with the purely historical data.

ETA: FIRECalc calculates what would have happened during your retirement period if you retired starting in 1920, or 1921, or 1922, etc.. That's all it does. Changing the inflation for all years to 3% makes it even more divorced from reality.

 

[ChicagoGal]

Why do I get such a large difference between the required portfolio starting value using the FIRECalc default CPI rate when compared to the results I get when using CPI data that I acquired for the 50 year period between 1964 and 2013? Why do I get such a large difference between the required portfolio value using the default CPI rate when compared to the result I get using 3 percent as the rate of inflation.

Using an average will give you different results than using actual rates because of the timing and sequence of the actual rates. If inflation goes up 10% for 10 years and then is flat for 10 years, even though the average rate is 5%, the outcome will be different (and different still if the rate was flat for the first 10 years and then up 10% for the next 10).

That's why using averages is usually a tricky proposition. Also why people talk a lot here about the impact of having a bear market immediately after retirement.

 

[mathjak107]

there is not one retirement income planner that does not adjust income for inflation every year by the rate of inflation. that drives the amount you need to save upward as well as places performance demands on that money that may be way higher then actually needed.

but there is a huge flaw in that . the cpi has no one owning a home. everyone is computed as if they rented.

now the biggest chunk of all our spending dollars is in housing costs , to the tune of 30-40% of all median incomes . the cpi is weighted so the biggest effect comes from housing.

the fact is anyone with a fixed rate mortgage or paid off hiome is way ahead of that inflation curve since they are little effected compared to renters on the bulk of their income..

sure real estate taxes and maintaince goes up but spending as we age tends to look like a smile.

it goes up early on as we travel ,do and go places , drops like a rock between 70-80 and increases again after 80 as healthcare and gifting/charity increases.

that offsets much of the real estate tax increases and maintaince increases an owner sees as they age through retirement .

in fact a homeowner needs a lot less in retirement savings then all these calcultors show since they do not need any where nearly the inflation adjusting a renter does.

i have yet to see a financial planner or calculator make this distinction in the inflation adjustments to income it predicts.

this is one of the reasons we are watching our rent vs buy costs. although we rent we are getting close to where giving up the income on 300k or so and buying a co-op and cutting housing costs and inflation demands will be the better deal.

a better inflation computation for projecting out what you need to retire for a homeowner may be figuring 2% the first 10 years of retirement , zero the next 10 and 1% the next 10 years.

the amount of savings you need is drastically reduced by having a fixed rate mortgage or paid off home.

interesting data to think about that no one ever accounts for in discussions..

that isn't to say a renter can't offset much of that inflation by being able to put more money to work at higher returns since it isn't tied up in the house. they can , but the demands on savings amounts and inflation adjusting is very different for the two groups and never accounted for in planning calculations..

 

[Totoro]

the fact is anyone with a fixed rate mortgage or paid off hiome is way ahead of that inflation curve since they are little effected compared to renters on the bulk of their income.

Not sure it is that different. In my view owning your own house is just an investment in real estate. Whether you live in it or not is kind of irrelevant from a financial perspective.

The demands on savings amounts and inflation is just as if you allocate a portion of your investment to real estate, that's it.

Similar, a fixed rate mortgage is just an inflation hedge. You can buy these in other ways (TIPS for example).

Furthermore, depending on the area you live in there may be rent controls in place protecting you as a renter. And as you mentioned, maintenance, taxes etc .. all are inflation affected.

the amount of savings you need is drastically reduced by having a fixed rate mortgage or paid off home.

Only if you disregard the capital needed to buy and maintain the house, as well as property tax. Not to mention the illiquidity.

Much depends on which specific house you buy / rent, but in general I don't see how owning your own home is fundamentally different than renting.

I might be a bit biased, but this article really points out some interesting things: Why your house is a terrible investment

It's far from a no-brainer to own a house (again, financially speaking).

 

[mathjak107]

while it is a true you can invest elsewhere and gain a higher income from other investments on the money tied up in the house the fact is:

there is no question that all things being equal a paid off home or fixed rate mortgage will require less inflation adjusting then renting in most cases.

the home side of things is dealing with expenses , investing elsewhere is dealing with gains and income. different sides of the balance sheet..

it just may be easier for some of us to rent and deal with the higher rate of inflation with better performing assets elsewhere but that would be a different issue with a lot more variables .

if i owned i would do my inflation adjusting based on the fact i will not need those inflation increases yearly. returns from other investments would be reflected as performance and or income.

a homeowner with a paid off home will not need nearly that 3% inflation raise the calculators project every year ,especially because spending in general has been shown to fall off as well . that 3% figure also assumes you are renting not owning.

it really is not a buy vs rent question , only the effect of inflation on expenses.

a renter can have a larger income investing elsewhere but a larger effect from inflation as well.

they can work out the same but do require different calculations on inflation effect.

 

[mathjak107]

when you think about it , i think owning requires more money up front and less inflation adjusting down the road. renting requires the same amount of money only you can invest that money that would be tied up in the house so you basically in theory end up with higher inflation costs but higher potential income offsetting those increases.

i believe the savings amount needed in both cases are the same. you are trading off paying for the house and needing lower inflation adjustments vs renting where you are not prepaying a huge sum and can have all the money working for you offsetting those higher inflation adjustments.

amounts needed to save over a lifetime would pretty much be the same in either case.

 

[Animorph]

when you think about it , i think owning requires more money up front and less inflation adjusting down the road. renting requires the same amount of money only you can invest that money that would be tied up in the house so you basically in theory end up with higher inflation costs but higher potential income offsetting those increases.

i believe the savings amount needed in both cases are the same. you are trading off paying for the house and needing lower inflation adjustments vs renting where you are not prepaying a huge sum and can have all the money working for you offsetting those higher inflation adjustments.

amounts needed to save over a lifetime would pretty much be the same in either case.

That makes renters sound like "keep the mortgage" types!

Inflation will definitely hit the owners if they move to a new house. So they kind of take it in bigger chunks at long intervals.

I think renting is also paying some one to maintain the house for you. So if all things were perfectly equal that would be an added expense of renting.

And the owners have an additional sales commission expense if they don't sell it themselves.

 

[mathjak107]

i think if we take a step back , i think for the most part without a mortgage the needed budget will be much less then renting.

we own a bunch of investment properties in nyc and while the rent is over 2k a month in some the carrying costs are 1/2 that.


as a retiree my budget as an owner would be a lot less on a item that in the cpi consumes the most dollars and so when i throw the numbers in firecalc the inflation figues are really based on the largest expenditure going up yearly by a certain percent on a much larger number.

the cpi assumes no one owns and we all rent .

but as an owner that isn't the case. while my budget would be smaller as an owner the sensitivity to the largest component of the cpi is greatly reduced.

to be honest it seems llike such a simple question here but it really makes my hair hurst as to just what is taking place cpi wise and inflation adjusting wise..

 

[Animorph]

CPI-wise, my expense budget is essentially from 2004, adjusted by CPI. Except I do subtract out the P&I on my mortgage before calculating the CPI budget adjustment. I do the same in my detailed retirement planning. Works fine for us.

Entering the mortgage P&I separately in FIRECalc as a limited time, non-inflated expense is also quite beneficial as opposed to leaving the mortgage as a normal continuing expense.