User:Whaleknives/Inflation and retirement spending

Inflation
Inflation is an increase in the prices of goods and services over time. When prices rise, currency buys fewer goods and services. Inflation reduces the purchasing power of money and decreases its real or inflation-adjusted value versus its nominal value. A measure of price inflation is the inflation rate, the annual percentage change in a price index over time. The opposite of inflation is deflation, or a price decrease over time.





Inflation and retirement
A retirement plan that does not account for inflation and a decline in purchasing power could be successful at first but fail 10 to 15 years into retirement. When working your wages generally rise as the cost of goods and services increases. Your earnings "keep pace with inflation". When you are living off savings, inflation literally robs you of income.

Just as inflation varies from country to country, inflation will also vary across regions, and goods and services. BLS reports that from December 1982-December 2011, the CPI-E grew at an annual rate of 3.1% vs. 2.9% for the broader CPI. The agency attributes this difference to the fact that a greater proportion of seniors' spending goes to healthcare and housing — two areas that have seen above-average inflation over that time. An experimental inflation price index for seniors, the CPI-E, has been created for Americans 62 years and older. It has behaved more like the CPI-U than the CPI-W.

Some retirement income is better protected against inflation than others. For example, Social Security has an annual cost-of-living adjustment based on the consumer-price-index (CPI). This enables Social Security benefits to remain relatively immune to inflation. Delaying social security as long as possible is a good way to protect against inflation risk because as benefits increase up to age 70 a larger percentage of the individual’s retirement income plan will be inflation protected.

Historically inflation in the U.S. has averaged 3.4% per year since 1914, but only 2.4% over the past decade. A recent report by the Federal Reserve Bank of Philadelphia forecasts that inflation will stay around that level for the next decade. The Bureau of Labor Statistics (BLS), which publishes the Consumer Price Index (CPI) on inflation, also publishes what it calls a CPI for the elderly (CPI-E), which it classifies as households aged 62 or older.

Rather than assuming that inflation will stay low leading up to and during retirement, conservative investors use longer-term inflation numbers to help guide their planning decisions; 3% is a reasonable starting point. Investors should also customize their inflation forecasts based on their actual consumption. For example, food costs are often a larger share of retirees' spending than for the general population, while housing costs may be a lower.

Key inflation areas
While the overall rate of inflation affects us all, retirees and those thinking about retirement need to be aware of how rising prices in a few key areas will affect their planning.

Healthcare: No other area better illustrates how spending habits change as we grow older. In a 2009-10 BLS survey, households with members age 62 and older reported spending 11.3% of annual disposable income (that's income after taxes) on healthcare, including insurance. The average for all households, including the elderly, was 6.9%. Medical costs have outpaced overall inflation each of the past 29 years except for 1996, according to the BLS, and have grown 5.1% annually in that time frame. For those planning for retirement — and in particular for those who currently have medical issues or a family history of them — the rising cost of healthcare should be a major factor in your considerations.

Housing: Senior households spend 44.5% of their disposable income on housing, including utilities, slightly above the 40.2% spent by the general population, according to the survey. Many retirees have homes that are paid off, and for those who don't but who currently pay fixed-rate mortgages, inflation needn't be a concern because payments will not rise. However, property taxes, insurance, home repair costs, and other homeowner expenses likely will. In 2011 property tax collections nationwide rose by only 1.2% due partly to depressed home values, but it was the first time they had risen below the rate of inflation since 1995. Retirees who rent homes also face the prospect of paying more as renting costs increase with inflation.

Energy: Though seniors tend to spend less on transportation than their younger counterparts, it remains a major expense, eating up 14.5% of disposable income vs. 16.5% for the overall population. Energy price volatility has become commonplace, with prices increasing an average of 4.6% per year over the past five years. Even for seniors who don't drive, this can translate into higher costs for travel, public transportation, and consumer goods that have to be shipped.

Food: Senior households spend 12.8% of disposable income on food, about two points below the overall population. But, as with energy, commodity volatility can cause spikes in costs for basic goods. Over the past five years, food prices have climbed 3.3% on average, and this summer's drought across much of the U.S. is expected to drive prices higher, affecting virtually everyone.

Inflation protection
The possibility that inflation could run higher than it is today also argues for laying in hedges in your retirement portfolio to help preserve purchasing power once you begin spending your retirement assets. That means stocks, which historically have had a better shot of outgaining inflation than any other asset class, as well as Treasury Inflation-Protected Securities and I-Bonds, commodities, precious-metals equities, and real estate. The good news is that most of these asset classes — apart from stocks — are arguably trading cheaply today, as discussed here.

Annuities often offer the ability to purchase either a set inflation increase in benefits — for example, 5% per year — or allow inflation protection based off of an index, like the CPI. Long-term care insurance also offers inflation protection to ensure the benefits do not lose their purchasing power over a long retirement. However, purchasing too much inflation protection can create an added cost that can end up reducing the total returns for the retiree.

One of the best ways to reduce the potential risk of inflation is to delay retirement as long as possible. Salaries typically adjust quickly due to high levels of inflation and many jobs offer annual increases in pay to adjust for changes in the cost of living. If you are in a defined benefit plan, working as long as possible can help protect your benefits since they are often tied to your average highest three years of salary. You could potentially see a significant increase in benefits if inflation rises and your salary adjusts accordingly. Profit-sharing and 401(k) account benefits will not adjust as rapidly if inflation increases during the last few years of employment.

Fixed income (bonds, C.D.s, and other “safe” investments that guarantee a certain level of return) can be significantly affected by inflation. For example, if a bond offers 3.5% annual returns nominally but inflation is 4% per year, the bond’s real interest rate is actually negative because the returns are not keeping up with inflation. In recent years bond rates have been historically low, increasing the risk that inflation could erode the purchasing power of the investment. The U.S. does offer Treasury Inflation Protected Securities (TIPS) which are CPI-adjusted bonds designed to keep pace with inflation. According to American College Professor Wade Pfau, TIPS can be used to create an inflation-protected retirement income plan.

Stocks are often mentioned as the investor’s most reliable hedge against inflation. Historically, equities have performed well over long periods of time, such as a 30 year period, when compared to inflation. However, the performance of equities as a hedge against inflation begins to suffer when inflation exceeds 5%. Even in times of high inflation, equities still tend to perform better than traditional bonds as inflation protection. While equities are not a perfect hedge against high short-term inflation, over the long run a well diversified stock portfolio, taking into consideration international stocks, can provide inflation protection.

There are other options to limit inflation risk in retirement, such as investing in dividend paying equities, investing in commodities, or purchasing I-Bonds. I-Bonds are particularly well positioned to handle inflation because they earn interest through a mix of inflation and fixed rates. The government does limit individuals purchases. Home prices and rental income often adjust well for inflation. Tapping into home equity during retirement or having rental income as part of one’s retirement plan can help offset some inflation.

Inflation and the decline of purchasing power is a serious risk for approaching retirees, as future inflation rates remain unknown. When planning for retirement, consider the long-term effects and the uncertainty of inflation over the expected period. If someone plans to be retired for 20 years, it would be helpful to see the highest and lowest cumulative impacts of inflation rates for a 20-year period in the U.S. While inflation risk is a major concern, it can be mitigated through proper planning and by including inflation protected investments in a retirement income plan.

Inflation and retirement calculations
Just as projected returns are used to predict future savings balances, projected inflation rates are used to predict future spending.

Inflation factor
The inflation factor is a multiplier used to convert a current amount to a future inflated amount. Pn = P(1+i)n, where Pn = Inflated cost after n years, P = Current cost, i = Inflation rate, n = Years, and (1+i)n = Inflation factor.

For example, $100,000 in 10 years at 3% annual inflation will require

"P10 = $100,000(1+0.03)10 = $100,000(1.34) = $134,000 future dollars, where 1.34 is the inflation factor."

Alternatively, for a spreadsheet calculating an annual expense over a range of years, the factor 1.03 can be applied to each previous year's value.

Retirement calculators
There are 37 free and 13 priced retirement calculators listed in the Bogleheads Wiki. Most of these calculators use an inflation rate to adjust future spending. AARP Retirement Calculator Annual inflation rate input; default is 2.5%. Crowdsourced FIRE Simulator "'Inflation Adjusted': This increases your spending each year by the amount of inflation indicated in the Inflation Assumptions section on the sidebar. This means that your "spending power" remains the same throughout retirement. By default, Inflation Assumptions is set to use the Consumer Price Index (CPI) for it's calculations, which is the generally accepted rule-of-thumb for inflation." Financial Engines "Forecast amounts are in today's dollars, which means that they have been adjusted for inflation. Forecasts are created by generating thousands of hypothetical future economic scenarios to evaluate how an investment portfolio might perform under a variety of circumstances, including changing interest rates, inflation, and market conditions. To create a consistent retirement income in today's dollars, any benefit specified in future dollars is converted to today's dollars." FIRECalc 3.0 Producer Price Index (PPI), Consumer Price Index (CPI), or constant inflation rate are used to adjust spending and "historical data". Are my current retirement savings sufficient?, Motley Fool, retrieved July 31, 2016. Expected inflation % input. Offers chart on 10 years annual inflation rates from DOL (2006-2015) and average of 1.9%. Optimal Retirement Planner The allowable spending calculated by the Optimal Retirement Planner is similar to that from a Life Cycle retirement calculator: it gives the maximum, constant real spending for the entire retirement lifespan. Otar Retirement Calculator A free Trial Version of the Otar calculator can be downloaded. You need to have Excel 2007 or later to run it properly. The trial version has full functionality except that the starting age is fixed at 55. For calculators that use historical returns, such as FIRECalc, both spending and returns are adjusted for inflation. FIRECalc 3.0 Producer Price Index (PPI), Consumer Price Index (CPI), or constant inflation rate are used to adjust spending and "historical data". The inflated spending default will try to maintain constant purchasing power, but there may be options to change spending as retirement progresses or portfolios decrease.

Social Security Administration calculators

 * All earnings are indexed to the national average wage index (AWI). Future earnings are indexed with estimated increases in the AWI. Earnings are indexed only to age 60 (two years prior to the first year of eligibility, 62); later earnings are used at face value. These increases are derived from the "intermediate" assumptions in the 2015 OASDI Trustees Report.
 * Although Social Security documentation suggests that future benefits are increased with estimated cost-of-living adjustments (COLAs), the estimates from my Social Security, Retirement Estimator, and the default Detailed Calculator (AnyPIA) do not project benefit increases beyond the current year. AnyPIA does offer the following increased benefit options:
 * 1) Alternative I (optimistic) assumptions from the most recent OASDI Trustees Report.
 * 2) Alternative II (intermediate) assumptions from the Trustees Report.
 * 3) Alternative III (pessimistic) assumptions from the Trustees Report.
 * 4) No benefit increases after the last known increase (default).
 * 5) User-specified benefit increase for each projected year.

Automatic Determinations, Office of the Chief Actuary

Several important parameters affect Social Security's Old-Age, Survivors, and Disability Insurance (OASDI) program and the Supplemental Security Income (SSI) program. We determine these parameters each October by following formulas set by law. Two important parameters are the national average wage index and the cost-of-living adjustment (COLA). COLAs and wage-indexed amounts for recent years are summarized in a table. The table's column headings provide links to more detailed data.

We use the national average wage index to "index" earnings for initial benefit computations and to determine several wage-indexed amounts that primarily affect the OASDI program.

COLAs provide annual increases in payments from OASDI and SSI programs.

Automatically increased amounts, as described above, are published in the Federal Register in late October. Choose the fourth selection if you do not want any future average wage increases. This is the recommended assumption for projecting future benefits. You can compare a benefit estimate with no future inflation to your current income and expenses for retirement planning.

AnyPIA

Choose the fourth selection if you do not want any future average wage increases. This is the recommended assumption for projecting future benefits. You can compare a benefit estimate with no future inflation to your current income and expenses for retirement planning.

No future average wage increases (Assumptions form) The stored average wage increases for this selection are initially set to zero for all years after the last known average wage. This is the recommended assumption for projecting future benefits. You can compare a benefit estimate with no future inflation to your current income and expenses for retirement planning.

No future benefit increases (Assumptions form) The stored benefit increases for this selection are initially set to zero for all years after the last known benefit increase. This is the recommended assumption for projecting future benefits. You can compare a benefit estimate with no future inflation to your current income and expenses for retirement planning.

Inflation data
Overview of BLS Statistics on Inflation and Prices, retrieved July 31, 2016. Inflation can be defined as the overall general upward price movement of goods and services in an economy. BLS has various indexes that measure different aspects of inflation.

BLS statistics related to inflation:

Consumer Price Index
The Consumer Price Index (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services. There are separate indexes for two groups of consumers:


 * The CPI for All Urban Consumers (CPI-U) is the index most often reported by the national media.
 * The CPI for Urban Wage Earners and Clerical Workers (CPI-W) is the index most often used for wage escalation agreements.

The CPI Inflation Calculator allows users to calculate the value of current dollars in an earlier period, or to calculate the current value of dollar amounts from years ago.

Consumer price indexes often are used to escalate or adjust payments for rents, wages, alimony, child support and other obligations that may be affected by changes in the cost of living.

An additional price index called the Chained Consumer Price Index (C-CPI-U) is also available. This measure is designed to be a closer approximation to a "cost-of-living" index than the CPI-U or CPI-W.

xx CPI-E

Producer Price Indexes
The Producer Price Indexes (PPIs) are a family of indexes that measure changes in the selling prices received by domestic producers of goods and services. They formerly were referred to as Wholesale Price Indexes. When the PPIs are released, the news media will most often report the percentage change in the index for Finished Goods.

Contract Escalation
Consumer Price Indexes, Producer Price Indexes, and the Employment Cost Index may be used to escalate contracts. See the Contract Escalation page for more information.

Personal inflation rate
Knowing precisely how inflation will affect your spending in retirement may not be possible, but if you're close to retiring and know your expenses, you can estimate it with a weighted personal inflation rate:
 * 1) Start with an annual budget of expenses, using the Key Areas above and your own categories.
 * 2) Calculate each category as a percentage of your total expenses.
 * 3) Choose an inflation rate for each category.
 * 4) Multiply each category's percentage of total spending by the category inflation rate. For example, if 15% of your expenses are for medical care, which you estimate at 5% inflation, then 0.15 x 5).
 * 5) Add the results for a weighted personal  inflation rate in retirement.

Cost-of-living allowance
The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. It does not control inflation, but rather seeks to mitigate the consequences of inflation for those on fixed incomes. Salaries are typically adjusted annually in low inflation economies. During hyperinflation they are adjusted more often. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves.

Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments ("COLAs") or cost-of-living increases because of their similarity to increases tied to externally determined indexes.