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. 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 most commonly accepted measure of inflation is the Consumer Price Index (CPI) published by the Bureau of Labor Statistics (BLS).

Rather than assuming that inflation will stay low before 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 argues for protecting your portfolio to preserve the purchasing power of future withdrawals. That means stocks, Treasury Inflation-Protected Securities and I-Bonds, commodities, precious-metals equities, and real estate, according to Christine Benz of Morningstar.

Working Longer: But first, one of the best ways to reduce the potential risk of inflation is to delay retirement as long as possible. Salaries typically adjust quickly to high levels of inflation and many jobs offer annual increases for changes in the cost of living. If you are eligible for a defined benefit plan, working longer can increase benefits that are tied to a higher average salary. Profit-sharing and 401(k) benefits do not adjust as rapidly to inflation in the last few years of employment.

Stocks: Stocks are considered the investor’s most reliable hedge against inflation, historically performing better than any other asset class. However, stock performance against inflation begins to suffer when it exceeds 5%. Even in times of high inflation, though, equities still perform better than traditional bonds. Over the long run a well diversified stock portfolio, including international stocks, can provide inflation protection.

TIPS and I-Bonds: Fixed income investments (bonds, CDs, and others that guarantee a return) can be significantly affected by inflation. If a bond offers 3.5% annual return nominally but annual inflation is 4%, the bond’s real interest rate is actually negative. Treasury Inflation Protected Securities (TIPS) and I-Bonds, however, offer inflation protection by adjustments based on the Consumer Price Index (CPI-U). Larry Swedroe says "The academic research makes clear that the best hedge against unexpected inflation is Treasury Inflation Protection Securities (TIPS)".

Annuities: Annuities can provide inflation protection with a fixed annual increase in benefits (e.g., 5% per year) or a variable increase with an index like the CPI. However, purchasing inflation protection adds cost that can reduce returns. A Single Premium Immediate Annuity (SPIA) covering two to four decades of retirement should use an inflation-indexed income annuity or a graded income annuity with a higher (3% or 4%) annual income adjustment. See Immediate fixed annuity in the Bogleheads&reg; Wiki.

Commodities: Commodities provide inflation protection because they are either Consumer Price Index (CPI) basket goods, or they are used to provide other goods in the CPI: gasoline and natural gas (transportation and housing), copper and aluminum (home construction and durable goods), corn, coffee, and cocoa (food), cotton (apparel), and silver (jewelry). Commodity indices also tend to be heavily weighted toward energy and food, providing protection for the two most volatile components of the CPI. See Commodities in the Bogleheads&reg; Wiki; the Risk section is blank.

Real Estate Investment Trusts (REITs): William Bernstein recommends "with some trepidation" considering REITs as one of only two possible sector investments due to a low correlation with other financial markets. The Bogleheads&reg; Wiki says "REITs are weakly correlated to inflation, due to their hard asset/rental income nature", but adds "if you are looking specifically for inflation protection, use individual TIPS, held to maturity"; see Real estate investment trust.

Home equity: Withdrawing home equity is sometimes described as a "loan of last resort", but it can be a resource for unexpected costs or reduced savings if you don't want to sell. Wade Pfau has said that "a standby line-of-credit through the FHA Home Equity Conversion Mortgage (HECM) program can be accessed to meet spending goals as necessary, reducing the sequence of returns risk in retirement and preventing retirees from selling assets after a market decline. An early, unused HECM line of credit may lose equity through initial closing costs and annual FHA insurance premiums, however. See Home equity loan, Home equity line of credit, and Reverse mortgages in the Bogleheads&reg; Wiki.

Rental property: Andrew Tobias and some Forum posters remind us that rental properties are not just an investment but also a business, and running a business is a job, requiring the time, interest, and ability.

Gold and other precious metals: William Bernstein recommends "with some trepidation" considering precious metals stock funds as one of only two possible sector investments. In spite of low returns, these funds in companies that mine gold, silver, platinum and others have little correlation with other financial markets, do well during periods of high inflation, and have returns that benefit from rebalancing. Unlike bullion, gold mining stocks pay shareholders dividends. The Lazy portfolios of Harry Browne is a buy-and-hold portfolio that contains equal shares of gold bullion, domestic stocks, short-term treasury bills, and long term treasury bonds. Blackrock iShares has an ETF version of this portfolio. See also Gold and Precious metals equity in the Bogleheads&reg; Wiki.

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 current or nominal dollars into constant or real dollars in the future. Pn = P(1+i)n, where Pn = inflated cost after n years, P = current cost, i = average annual 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 calculations of an annual expense over a range of years, the factor 1.03 can be applied to each previous year's value.

If indexes like the Consumer Price Indexes are used instead of an inflation rate, then a ratio of the index values for the appropriate two years can be used as the inflation factor. See "Math calculations to better utilize CPI data"

Retirement calculators
There are 37 free and 13 priced retirement calculators listed in the Bogleheads&reg; 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. The default inflated spending will 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.

Social Security recommends using the default of no benefit increases after the last known increase because it allows comparing a benefit estimate to current income and expenses. It does not help evaluate the whether current savings are sufficient.

The Office of the Chief Actuary publishes new national average wage index and cost-of-living adjustment (COLA) data in the Federal Register in late October.

Inflation data
The Bureau of Labor Statistics publishes various indexes that measure different aspects of inflation.

Consumer Price Indexes
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 various 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 adjustments.
 * An experimental CPI for the Elderly (CPI-E) was created for Americans 62 and older, but is no longer published.
 * The Chained CPI (C-CPI-U) was intended to improve on the CPI-U and CPI-W, but has been controversial.

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.



The CPI-E during its life behaved more like the CPI-U than the CPI-W. The chart data shows less than 5% difference between the CPI-E and CPI-U category percentages. From December 1982 through December 2011, the CPI-E rose at an annual rate of 3.1 percent, compared with increases of 2.9 percent for both the CPI-U and CPI-W.

Older Americans faced slightly higher inflation from 1983 to 2011, due to their greater share of medical care and shelter. Medical care inflation was greater than most other goods and services (5.1% vs 2.8%), and shelter costs have modestly outpaced overall inflation. However, from 2006 to 2011 both the CPI-E and CPI-U rose at an annual rate of 2.3%, while the CPI-W increased 2.4%. This turnaround was caused by changes in the inflation rates of medical care and shelter: the gap between medical care inflation and overall inflation has generally fallen since 2005, and shelter inflation has been rising more slowly. The last published data for the CPI-E was 2011.

The Chained Consumer Price Index (C-CPI-U) is a an alternative CPI-U. It assumes that inflation causes consumers to continuously choose less-expensive substitutes, reducing price increases by reducing the quality of goods and services consumed. The CPI-U also takes substitutions into account, but does it more slowly by a periodic adjustment of the representative basket. A proposal to apply the chained CPI to federal benefits such as Social Security to reduce the deficit has been controversial.

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.

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.