Estimating Inflation in Retirement

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tedfl
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Estimating Inflation in Retirement

Post by tedfl » Thu Jun 06, 2019 7:27 pm

Most web sites suggest using 3%.basing it off the average rate since WW2. I think over the last 20 years it is more like 2-2.5%.
Most retired folks have no mortgage and slow down there spending as they get older so how do you guys account for this?
It seems trying to estimate inflation is akin to estimating rate of return. What's the best way to do it?

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Re: Estimating Inflation in Retirement

Post by prudent » Thu Jun 06, 2019 7:46 pm

https://www.bls.gov/opub/ted/2012/ted_20120302.htm

That data is from 2012 but it talks about the goverment-calculated Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W) compared to the CPI for the elderly (CPI-E). It shows that from 1982-2011, CPI-E rose an average of 3.1% annually vs. 2.9% for CPI-W. But also notes that in the tail end of that study (2006-2011), CPI-E averaged 2.3% and CPI-W averaged 2.4% annually. Also has a graph comparing spending in different categories for each group (as well as the Consumer Price Index for All Urban Consumers (CPI-U) ).

I plan against a 2.5% inflation as the data seems to indicate that's a reasonable number. Medical expense is certainly a wildcard, but many other categories of spending I can control. I can cut back on charitable contributions, dining out, travel, etc. if I need to - the idea that I can influence my "personal" inflation rate vs. what prices in general end up doing.

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Re: Estimating Inflation in Retirement

Post by LadyGeek » Thu Jun 06, 2019 7:47 pm

This thread is now in the Personal Finance (Not Investing) forum (retirement planning).
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Re: Estimating Inflation in Retirement

Post by jebmke » Thu Jun 06, 2019 7:48 pm

I don't even try. What little planning I do I do in real dollars.
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Re: Estimating Inflation in Retirement

Post by JoeRetire » Thu Jun 06, 2019 7:55 pm

tedfl wrote:
Thu Jun 06, 2019 7:27 pm
Most web sites suggest using 3%.basing it off the average rate since WW2. I think over the last 20 years it is more like 2-2.5%.
Most retired folks have no mortgage and slow down there spending as they get older so how do you guys account for this?
It seems trying to estimate inflation is akin to estimating rate of return. What's the best way to do it?
I go with 3% since that's approximately the long term rate over the last 100 years or so. Perhaps that's conservative, but I lived through times when my mortgage rate was in the double digits and days when inflation was running wild. Not all expenses slow down as you get older.

You can pick any number that makes you feel comfortable for a 30+ year retirement period.

Maybe the next 30 years will be like the most recent 20. Maybe not.

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Re: Estimating Inflation in Retirement

Post by nisiprius » Thu Jun 06, 2019 8:03 pm

1) Like jebmke, I did all my planning in real dollars.

2) No point in worrying about whether the inflation rate is going to be 2.5% or 3%. You can't be that precise. Whatever you make is just a wild guess. It's probably safer to assume 3%. But it doesn't matter anyway.

The important question is not "2.5% or 3%. It's a yes-or-no question. Will the low, stable inflation we've had since Volcker persist? Or will we experience a period of 15-18% inflation like 1917-1920, or 14% inflation like 1947, or 10-13% inflation like 1979-1981... or Zimbabwe, Weimar Germany, or current-Venezuelan-style hyperinflation? And the answer to that question is that nobody knows.

3) No, 3% inflation isn't "since World War II." The average annual inflation 1946-2014 (the reference volume I'm using is a little out-of-date) was 3.8%. For 1926-2014 the annualized average was 2.9%. The BLS CPI data is easy to find and goes back to 1913, and Jan. 1913 to Jan. 2019 averaged 3.1%. The "3%" number is probably "all available data," not "since World War II."

But in any case, even barring an episode of double-digit inflation, any number from 2% to 4% is perfectly plausible.

4) I don't believe in the "expenses slow down as you get older" meme. It popped up rather suddenly within the last ten years and people have pounced on it at little too enthusiastically, because it makes all the retirement planning calculations come out better. Even if it's true on the average, individual variation is going to be huge. For every senior who's too frail to travel, there's another senior who's eager to travel but too frail to fly basic economy. Seniors who can afford it are likely to start spending more on "comfort" items. My wifes' folks started buying bigger and more comfortable cars in their later years, for example.
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Re: Estimating Inflation in Retirement

Post by vineviz » Thu Jun 06, 2019 8:19 pm

tedfl wrote:
Thu Jun 06, 2019 7:27 pm
Most web sites suggest using 3%.basing it off the average rate since WW2. I think over the last 20 years it is more like 2-2.5%.
Most retired folks have no mortgage and slow down there spending as they get older so how do you guys account for this?
It seems trying to estimate inflation is akin to estimating rate of return. What's the best way to do it?
You'll find many ways to think about it, but I try to keep it simple. The market is expecting inflation over the next 30 years to be just slightly under 2%, so I take that as reasonable an estimate as any.

There are two parts to your question,though, and inflation is only one of them. The other is your level of spending, and no one is better positioned than you to estimate this. If your retirement plans depend in getting this number right, you probably should hire a Certified Financial Planner for an hourly fee or flat fee to help you work through it.

But the broad stroke is that for most retirees, spending averages about 1% below inflation. So if inflation is 2%, you can probably forecast that your spending will grow about 1% per year. Many people spend in a pattern called the "retirement smile".

Image

This results from relatively high spending in the first years of retirement (leisure travel, dining out, hobbies, etc.) a slow down in middle years (reduced mobility, reduced cognition, etc0 and then higher spending again in later years (more health care expenses, retirement community, relocation, etc.).

Some of this depends on your net worth, how flexible your spending is, etc. but absent some other details I'd say expecting inflation to be 2% and your spending to grow at 1% would be a reasonable base case.
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Re: Estimating Inflation in Retirement

Post by nisiprius » Thu Jun 06, 2019 8:23 pm

Honestly, vineviz, if all you saw were those data points, and asked you to fit a curve to them by eye, would you draw that "smile" curve? Either of them?

And if it's valid, why should the "smile" curve fit, based on age 65-75 (solid line) be so utterly different from the curve based on 60-85 (dotted line)? I can't even begin to make sense out of that. (I'm assuming that's what those two curves are; that is, I'm assuming the chart you posted is similar to figure 2 of Exploring the Retirement Consumption Puzzle).

"And with my luck, I'll be one of the dots that isn't even close to that curve..."
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Re: Estimating Inflation in Retirement

Post by vineviz » Thu Jun 06, 2019 9:05 pm

nisiprius wrote:
Thu Jun 06, 2019 8:23 pm
Honestly, vineviz, if all you saw were those data points, and asked you to fit a curve to them by eye, would you draw that "smile" curve? Either of them?
I seem to recall some statistical technique for finding the relationship of data points that doesn’t rely on fitting curves by eye. Possibly I studied it in an undergrad or masters statistics class.

There was something about independent and dependent variables.

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Re: Estimating Inflation in Retirement

Post by MotoTrojan » Thu Jun 06, 2019 9:10 pm

Just make projections in real returns.

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Re: Estimating Inflation in Retirement

Post by carolinaman » Fri Jun 07, 2019 12:42 pm

I use 3% which is higher than recent inflation but gives me some cushion when inflation does go higher.

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Re: Estimating Inflation in Retirement

Post by Coltrane75 » Fri Jun 07, 2019 2:44 pm

I also do projections in real dollars.

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Re: Estimating Inflation in Retirement

Post by marcopolo » Fri Jun 07, 2019 4:13 pm

vineviz wrote:
Thu Jun 06, 2019 9:05 pm
nisiprius wrote:
Thu Jun 06, 2019 8:23 pm
Honestly, vineviz, if all you saw were those data points, and asked you to fit a curve to them by eye, would you draw that "smile" curve? Either of them?
I seem to recall some statistical technique for finding the relationship of data points that doesn’t rely on fitting curves by eye. Possibly I studied it in an undergrad or masters statistics class.

There was something about independent and dependent variables.

Hang on, it’ll come to me.
What order curve fitting was used?
It appears that it was likely a 2nd order polynomial, which will of course produce a smile.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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Re: Estimating Inflation in Retirement

Post by Nestegg_User » Fri Jun 07, 2019 4:29 pm

hmmm.... r squared of 0.3 ...... trying to fit noise

(and not enough power to rely upon)
looking at the data.... indistinguishable from no change at all, if you include the error bars around the regression, which has a very large sd



(I used 3% inflation in my prior planning, as the Fed target was 2% and they are more reactive than proactive so went up a bit)
Last edited by Nestegg_User on Fri Jun 07, 2019 4:36 pm, edited 2 times in total.

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Re: Estimating Inflation in Retirement

Post by Sandtrap » Fri Jun 07, 2019 4:31 pm

jebmke wrote:
Thu Jun 06, 2019 7:48 pm
I don't even try. What little planning I do I do in real dollars.
+1
Keep it simple.
j :happy

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Re: Estimating Inflation in Retirement

Post by vineviz » Fri Jun 07, 2019 4:52 pm

marcopolo wrote:
Fri Jun 07, 2019 4:13 pm
It appears that it was likely a 2nd order polynomial, which will of course produce a smile.
Only if that's the best fit, though.

A 2nd order polynomial regression can produce a trend line anywhere from fully convex to fully concave, and virtually any intermediate shape (including a flat or sloped line).
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Re: Estimating Inflation in Retirement

Post by tedfl » Fri Jun 07, 2019 5:53 pm

What do you guys mean by "real dollars"? You don't adjust SS/pension by colas?

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Re: Estimating Inflation in Retirement

Post by jebmke » Fri Jun 07, 2019 5:58 pm

tedfl wrote:
Fri Jun 07, 2019 5:53 pm
What do you guys mean by "real dollars"? You don't adjust SS/pension by colas?
No, I do everything in today's prices. My pension is non-COLA so technically, do do it correctly in real dollars I should discount it every year. But I don't. The world just isn't that precise. I don't do a lot of projections anyway. The main thing I do is a pro-forma tax return for every year of inflection (pension start, SS start, RMD start). For these I assume everything is static except incremental income.
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Re: Estimating Inflation in Retirement

Post by oxothuk » Fri Jun 07, 2019 6:12 pm

Fortunately SS is sufficient to cover my needs (at a “genteel-poverty” level) and SS is indexed.

For the rest of my portfolio I assume (hope) that investment performance will match inflation. I don’t need to do any better than that.

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Re: Estimating Inflation in Retirement

Post by abuss368 » Fri Jun 07, 2019 7:39 pm

tedfl wrote:
Thu Jun 06, 2019 7:27 pm
Most web sites suggest using 3%.basing it off the average rate since WW2. I think over the last 20 years it is more like 2-2.5%.
Most retired folks have no mortgage and slow down there spending as they get older so how do you guys account for this?
It seems trying to estimate inflation is akin to estimating rate of return. What's the best way to do it?
I would not even try. Keep it simple. Problem is there could be a different impact from inflation for anyone. Someone who requires a lot of medicine and health care may be more exposed to inflation than others.
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Re: Estimating Inflation in Retirement

Post by IMO » Fri Jun 07, 2019 11:16 pm

tedfl wrote:
Thu Jun 06, 2019 7:27 pm
Most web sites suggest using 3%.basing it off the average rate since WW2. I think over the last 20 years it is more like 2-2.5%.
Most retired folks have no mortgage and slow down there spending as they get older so how do you guys account for this?
It seems trying to estimate inflation is akin to estimating rate of return. What's the best way to do it?
The problem I have with inflation indices is that many many things in life really do not follow the indices. I could go on and on and list things that have well exceeded inflation indices.

Personally I think the best way to plan for it is to make sure one's budget for retirement has plenty of budget for discretionary items and to also put an overall fudge factor in for protection. So if you have a budget of $50,000 that seems pretty solid with a good amount in for discretionary things, then pick a comfort factor above that. For example 10% or 20%. So in that case you'd probably be okay with a budget of $55,000 or $60,000 when picking your number. One can always cut back on discretionary things if needed temporarily or permanently if push comes to shove.

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Re: Estimating Inflation in Retirement

Post by J295 » Fri Jun 07, 2019 11:18 pm

Inflation is one of many unknowns. I don’t estimate it.

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Re: Estimating Inflation in Retirement

Post by carolinaman » Sat Jun 08, 2019 7:44 am

It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.

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Re: Estimating Inflation in Retirement

Post by JoeRetire » Sun Jun 09, 2019 5:32 am

carolinaman wrote:
Sat Jun 08, 2019 7:44 am
It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.
Planning is hard. It's easier to pretend the future will be like the recent past.

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Re: Estimating Inflation in Retirement

Post by jebmke » Sun Jun 09, 2019 8:18 am

carolinaman wrote:
Sat Jun 08, 2019 7:44 am
It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.
Because (some) people are not attempting to forecast inflation doesn't mean they are ignoring it.
When you discover that you are riding a dead horse, the best strategy is to dismount.

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Re: Estimating Inflation in Retirement

Post by Nestegg_User » Sun Jun 09, 2019 8:54 am

as I noted above, I didn't ignore it... in my planning I used 3% (roughly what it was in prior periods) but investigated if it went to 5% in ruggedness tests. I also gave my numbers a 25% fudge factor above my running average costs (which included one-offs) in planning, as well as the possibility of negative returns. You can't make it bulletproof but you can make it conservative enough to not badly delude yourself that you could retire when, in reality, you are not quite there yet.

(for us, we're under 2 1/2% draw and haven't started SS.... but that's when everything worked out.... could have gone the other way. You pack your own chute.... it has to work)
Last edited by Nestegg_User on Sun Jun 09, 2019 1:44 pm, edited 1 time in total.

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Re: Estimating Inflation in Retirement

Post by vineviz » Sun Jun 09, 2019 10:39 am

jebmke wrote:
Sun Jun 09, 2019 8:18 am
carolinaman wrote:
Sat Jun 08, 2019 7:44 am
It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.
Because (some) people are not attempting to forecast inflation doesn't mean they are ignoring it.
It pretty much does mean that. You're either accounting for expected inflation in your plans or you're not, right?
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Estimating Inflation in Retirement

Post by Silk McCue » Sun Jun 09, 2019 10:55 am

vineviz wrote:
Sun Jun 09, 2019 10:39 am
jebmke wrote:
Sun Jun 09, 2019 8:18 am
carolinaman wrote:
Sat Jun 08, 2019 7:44 am
It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.
Because (some) people are not attempting to forecast inflation doesn't mean they are ignoring it.
It pretty much does mean that. You're either accounting for expected inflation in your plans or you're not, right?
If you project your expected rate of real return that is net of inflation you don't need to know the inflation rate. If your income sources from Social Security and Pension are adjusted for inflation rate then you don't need to know the inflation rate to know that your income keeps up with inflation. If you have a pension that does not have an inflation adjustment you have to decide how to deal with that.

So yes you can decide to not forecast the inflation rate while not ignoring it by the manner in which you model your future growth and spending.

Cheers

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Re: Estimating Inflation in Retirement

Post by tfunk » Sun Jun 09, 2019 10:56 am

When I got married in 1989 the CPI-U was at 121.1 (January) and I thought a $1 million portfolio target was good.

Now in January 2019 the CPI-U is at 251.7. So, that $1 million would be up to $2.1 million to have equal purchasing power.

That is a compound growth rate of 2.5% over the past 30 years.

I think it is important to set your portfolio target using some type of inflation projection.

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Re: Estimating Inflation in Retirement

Post by vineviz » Sun Jun 09, 2019 11:03 am

Silk McCue wrote:
Sun Jun 09, 2019 10:55 am
If you project your expected rate of real return that is net of inflation you don't need to know the inflation rate.
If 100% of your expenses and 100% of your income are denominated in real dollars, then I guess that you win.

I'm also guessing that almost everyone else who participates on this forum has an investment portfolio which includes at least some amount of stocks and nominal bonds. Those people aren't quite as lucky as you.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Estimating Inflation in Retirement

Post by Silk McCue » Sun Jun 09, 2019 11:15 am

vineviz wrote:
Sun Jun 09, 2019 11:03 am
Silk McCue wrote:
Sun Jun 09, 2019 10:55 am
If you project your expected rate of real return that is net of inflation you don't need to know the inflation rate.
If 100% of your expenses and 100% of your income are denominated in real dollars, then I guess that you win.

I'm also guessing that almost everyone else who participates on this forum has an investment portfolio which includes at least some amount of stocks and nominal bonds. Those people aren't quite as lucky as you.
I think you missed my point. I certainly hold stocks and bonds. I will let others reply further.

Cheers

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Re: Estimating Inflation in Retirement

Post by jebmke » Sun Jun 09, 2019 11:20 am

vineviz wrote:
Sun Jun 09, 2019 10:39 am
jebmke wrote:
Sun Jun 09, 2019 8:18 am
carolinaman wrote:
Sat Jun 08, 2019 7:44 am
It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.
Because (some) people are not attempting to forecast inflation doesn't mean they are ignoring it.
It pretty much does mean that. You're either accounting for expected inflation in your plans or you're not, right?
I am not attempting to estimate future inflation. I have high return assets in my allocation (equity) and a large dose of Tips in my fixed income allocation. I have no idea what future inflation will be nor do I spend any time worrying about it. It isn't something I can control even remotely.
When you discover that you are riding a dead horse, the best strategy is to dismount.

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Re: Estimating Inflation in Retirement

Post by smitcat » Sun Jun 09, 2019 1:18 pm

Silk McCue wrote:
Sun Jun 09, 2019 10:55 am
vineviz wrote:
Sun Jun 09, 2019 10:39 am
jebmke wrote:
Sun Jun 09, 2019 8:18 am
carolinaman wrote:
Sat Jun 08, 2019 7:44 am
It is interesting that so many people ignore inflation in retirement planning yet it is considered one of the biggest risks for retirees.
Because (some) people are not attempting to forecast inflation doesn't mean they are ignoring it.
It pretty much does mean that. You're either accounting for expected inflation in your plans or you're not, right?
If you project your expected rate of real return that is net of inflation you don't need to know the inflation rate. If your income sources from Social Security and Pension are adjusted for inflation rate then you don't need to know the inflation rate to know that your income keeps up with inflation. If you have a pension that does not have an inflation adjustment you have to decide how to deal with that.

So yes you can decide to not forecast the inflation rate while not ignoring it by the manner in which you model your future growth and spending.

Cheers
Yup - thats what we do. Project various rates of real return net of inflation for planning.

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Re: Estimating Inflation in Retirement

Post by willthrill81 » Sun Jun 09, 2019 1:35 pm

Nestegg_User wrote:
Fri Jun 07, 2019 4:29 pm
hmmm.... r squared of 0.3 ...... trying to fit noise
In the social sciences, an R-squared of .3 is very respectable. It means that 30% of the variance in one variable is accounted for by your model.

Nonetheless, it means that 70% of the variance is due to other factors extraneous to your model. That's still quite a lot. I suspect that if we filtered out retirees' who had the ability to significantly increase their spending during retirement, we'd see the R-squared of the relationship between spending and age increase to something like .5 (i.e. 50%).

Still, an argument can be made to keep things slightly conservative and simpler by just estimating all of your expenses in today's dollars with no reduction in spending, ever.
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Re: Estimating Inflation in Retirement

Post by petulant » Sun Jun 09, 2019 1:43 pm

I think it's fine to do either real returns for your basic retirement planning or to do an explicit 2% or 2.5% assumption with nominal returns. I honestly think 3% or more is possible but not likely for USD retirees right now.

That said, I think an important exercise is to model or estimate how higher inflation would impact your financial situation, and consider ways to make your portfolio more resilient. For example, entering retirement as a renter with medium or long-term bonds at 50% of your portfolio, which would be consistent with but not required by the Bogleheads philosophy, would result in the retiree entering retirement with significant inflation risk. I would not be comfortable with it.

Compare that to a new retiree who owns their home w/o a mortgage (probably with a smaller portfolio) and who has a fixed income allocation of 50% with a large proportion in TIPS, and surprise inflation will be less a factor.

Compare even that to a new retiree who has a modest 30-year fixed mortgage on their home (and, hopefully, a slightly larger portfolio) along with a notable REIT allocation or a rental property with a modest mortgage--surprise inflation might actually benefit this retiree.

In other words, I would advise you to consider how to make a portfolio that is resilient against surprise high inflation while assuming reasonable inflation forecasts, not a portfolio that forecasts high inflation and thus results in a lower SWR or requires high asset accumulation.

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Re: Estimating Inflation in Retirement

Post by tedfl » Wed Jun 12, 2019 5:29 am

Thanks for all the great input guys!

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