Inflation and retirement spending

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Inflation and retirement spending describes the impacts inflation could have on your retirement and how to incorporate inflation in your retirement planning.

Overview

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. [1] 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. [2]

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). Delaying social security is good inflation protection because benefits increase up to age 70 and a larger percentage of retirement income will continue to be inflation protected. [3]

Historically annual inflation in the U.S. has averaged 3.4% since 1914, but only 1.9% from 2006 — 2015. 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 for All Urban Consumers (CPI-U) published by the Bureau of Labor Statistics (BLS). [4]

Rather than assuming that inflation will stay low before and during retirement, conservative investors use longer-term inflation numbers for planning; 3% is a reasonable starting point. Investors can also customize their inflation forecasts based on their actual consumption (see below). For example, food costs are often a larger share of retirees' spending than for the general population, while housing costs may be a lower. [5]

Inflation

"Some idea of inflation comes from seeing a youngster get his first job at a salary you dreamed of as the culmination of your career." — Bill Vaughn

"Inflation is when you pay fifteen dollars for a ten-dollar haircut you used to get for five dollars when you had hair." — Sam Ewing [6]

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 nominal (inflation adjusted) value versus its real 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. [7]


US-Inflation-by-year.png


Inflation 2006-2015 avg.gif


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 — 2010 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 outpaced overall inflation from 1983 — 2012 except for 1996 according to the BLS, and medical costs grew 5.1% annually in that time frame. [8] However, from 2006 — 2011 both the experimental CPI-Elderly (62 years and older) and the CPI-U rose at the same annual rate of 2.3%. This turnaround was caused by changes in 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. [9]

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, it remains a major expense, using 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 from 2007 — 2012. Even for those who don't drive, inflation increases costs for travel, public transportation, and shipping.

Food: Senior households spend 12.8% of disposable income on food, about two points below the overall population. But, as with energy, volatility can cause spikes. From 2007 — 2012 food prices climbed 3.3% on average. [10]

Inflation protection

The possibility that inflation could increase argues for protecting your portfolio to preserve the purchasing power of future withdrawals. According to Christine Benz of Morningstar, that means stocks, Treasury Inflation-Protected Securities, I-Bonds, commodities, precious metals, and real estate. [11] But there is something else to consider first.

Working Longer: 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 cost of living increases. With 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. [12]

Stocks: Stocks are considered the investor’s most reliable hedge against inflation, historically performing better than any other asset class, especially traditional bonds. [13] However, even stock performance against inflation suffers when it exceeds 5%. Over the long run a well diversified stock portfolio, including international stocks, can provide inflation protection. [14]

TIPS and I-Bonds: Fixed income investments such as 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 has said that "the best hedge against unexpected inflation is Treasury Inflation Protection Securities (TIPS)". [15]

There may be less of a consensus on TIPS now, perhaps due to recency bias, as noted by Bogleheads® poster nedsaid:

The standard advice here used to be to put half of your bonds into TIPS. In recent years, a lot of folks have soured on them and have either sold them outright or exchanged them for shorter term TIPS. During the time I have owned them, TIPS pretty much tracked other investment grade bonds. During the 2008-2009 financial crisis, TIPS dropped in value by over 10% and those of us who owned them were surprised by their volatility. 2016 has been a good year for TIPS but there was a stretch of time before that when they lagged the US Bond Index. Thus many soured on them. I am keeping my allocation of TIPS to guard against unexpected inflation. [16]
The Bogleheads® Wiki notes that TIPS are not as tax efficient as I-Bonds, because the inflation adjustment and interest payments are taxable as ordinary income for federal income tax. For this reason it is often suggested that TIPS be held in a tax-advantaged account. [17] dodecahedron compared TIPS to I-Bonds:
ibonds have several advantages vs. TIPS. In a taxable account, TIPS can present bookkeeping challenges while ibonds are simple. Also ibonds are tax-deferred (interest not due until you cash in) and they provide deflation as well as inflation protection. (TIPS provide some deflation protection if held to maturity but ibonds provide deflation protection no matter how long you hold them.) Finally ibonds may offer tax advantages if used for qualifying education expenses. [18]

Annuities: Annuities can provide 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. [19] 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® Wiki.

Commodities: Commodities provide inflation protection because they are CPI basket goods themselves, and they are also used to provide other basket goods: transportation and housing (gasoline and natural gas), home construction and durable goods (copper and aluminum), food (corn, coffee, and cocoa), clothing (cotton), and jewelry (gold and silver). Commodity indices also tend to be heavily weighted toward energy and food, providing protection for the two most volatile components of the CPI. [20] See Commodities in the Bogleheads® Wiki; the Risk section is blank.

Real Estate Investment Trusts (REITs): William Bernstein recommends considering REITs due to their low correlation with other financial markets. [21] The Bogleheads® 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® Wiki.

Rental property: Andrew Tobias [22] and some Bogleheads® Forum posters [23] remind us that rental properties are not just an investment but also a business, and running a business is a job, requiring time, interest, and ability.

Gold and other precious metals: William Bernstein recommends considering stock funds in companies that mine gold, silver, platinum and other precious metals. In spite of low returns, these funds have little correlation with other financial markets, do well during periods of high inflation, and benefit from rebalancing. [24] Unlike bullion, gold mining stocks pay shareholder dividends. The Permanent Portfolio of Harry Browne 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 using iShares Gold Trust ETF. See also Gold and Precious metals equity in the Bogleheads® Wiki.

Instead of focusing only on investment diversification and allocations, manage retirement risk by combining those with hedging and insuring. See Matching strategies for retirement planning in the Bogleheads® 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

An inflation factor can be used to convert between current or real dollars and future or nominal dollars after inflation. For example,

    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. [25]

$100,000 in 10 years at 3% average 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" [26]

Retirement calculators

There are 50 retirement calculators listed in the Bogleheads® Wiki. Most of these calculators use an inflation rate to adjust future spending. [Note 1] For calculators that use historical returns, such as FIRECalc or Otar Retirement Calculator, both spending and returns are adjusted for inflation. [Note 2] 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 "Alternative II (intermediate)" assumptions in the 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. [27]

Inflation data

The Bureau of Labor Statistics publishes various indexes that measure different aspects of inflation. [28]

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) is an alternative CPI-U begun in July 2002.


Inflation 2006-2015 avg.gif


The average annual inflation values in the 2006 — 2015 chart above come from the following CPI data:

    Consumer Price Index - All Urban Consumers (CPI-U)
    12-Month Percent Change
    Series Id: CUUR0000SA0
    Not Seasonally Adjusted
    Area: U.S. city average
    Item: All items
    Base Period: 1982-84=100

and can be retrieved at CPI-U 12-Month Percent Change (select "include annual averages" and "Go", then page down to the table).

The same data can be obtained from the Federal Reserve Economic Data (FRED) site selecting "10Y", "Edit Graph", and

    Consumer Price Index for All Urban Consumers:
    All Items
    Index 1982-1984=100
    Not Seasonally Adjusted (CPIAUCNS)
    Units: Percent Change from Year Ago
    Modify frequency: Annual
    Aggregation method: Average.

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.

Cpi-e.png

The CPI-E during its life behaved more like the CPI-U than the CPI-W. [29] 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. [30] The last published data for the CPI-E was in 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. [31] The BLS designed the C-CPI-U to be a closer approximation to a cost-of-living index than the other CPI measures, but has taken no position on which index Congress or the Administration should use to make adjustments to Social Security or any other federal program. The C-CPI-U is not used currently as an adjustment mechanism. [32]

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.

Planning for inflation

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 your own personal inflation rate as follows:

  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. [33]

See also

Notes

  1. Some examples:
    • 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.
  2. From the websites:
    • FIRECalc 3.0 Producer Price Index (PPI), Consumer Price Index (CPI), or constant inflation rate are used to adjust spending and "historical data".
    • Otar Retirement Calculator uses the actual market history, including growth rate and inflation: "The program uses the historic inflation for each year since 1900. Between 1900-1913, it uses the US Bureau of Labor Statistics wholesale price index. . . After 1913, it uses the Consumer Price Index. The program uses these for indexing the periodic withdrawals/deposits for each age and for each year starting with the current age and ending at the specified age of death."

References

  1. Jamie Hopkins, "How To Mitigate Inflation Risk In A Retirement Income Plan", Forbes, March 30, 2014.
  2. "Inflation - Inflation Can Devastate Even a Good Retirement Plan", NewRetirement, retrieved August 1, 2016.
  3. Jamie Hopkins, "How To Mitigate Inflation Risk In A Retirement Income Plan", Forbes, March 30, 2014.
  4. Adam Zoll, "Don't Discount Inflation When Planning for Retirement", September 10, 2012.
  5. Christine Benz, "4 Dangerous Assumptions That Could Hurt Your Retirement Plan", Morningstar, February 5, 2015.
  6. "Inflation Can Devastate Even a Good Retirement Plan", NewRetirement, retrieved August 1, 2016.
  7. "Inflation", Wikipedia, retrieved August 1, 2016.
  8. Adam Zoll, "Don't Discount Inflation When Planning for Retirement", September 10, 2012.
  9. "Consumer Price Index for the elderly", Bureau of Labor Statistics, March 2, 2012.
  10. Adam Zoll, "Don't Discount Inflation When Planning for Retirement", September 10, 2012.
  11. Christine Benz, "4 Dangerous Assumptions That Could Hurt Your Retirement Plan", Morningstar, February 5, 2015.
  12. Jamie Hopkins, "How To Mitigate Inflation Risk In A Retirement Income Plan", Forbes, March 30, 2014.
  13. Christine Benz, "4 Dangerous Assumptions That Could Hurt Your Retirement Plan", Morningstar, February 5, 2015.
  14. Jamie Hopkins, "How To Mitigate Inflation Risk In A Retirement Income Plan", Forbes, March 30, 2014.
  15. Larry Swedroe, "Poking holes in the inflation conspiracy theory", MONEYWATCH, December 24, 2013.
  16. Bogleheads® forum topic: TIPs, I've read the posts, still confused, retrieved August 23, 2016
  17. Treasury Inflation Protected Security Tax considerations, Bogleheads® Wiki, retrieved August 24, 2016.
  18. Bogleheads® forum topic: TIPs, I've read the posts, still confused, retrieved August 23, 2016
  19. Jamie Hopkins, "How To Mitigate Inflation Risk In A Retirement Income Plan", Forbes, March 30, 2014.
  20. Denis Chaves, "Go for the Gold: Commodities and Inflation", Morningstar, December 11, 2014
  21. William J. Bernstein, The Four Pillars of Investing, McGraw-Hill, 2010.
  22. Andrew Tobias, The Only Investment Guide You'll Ever Need, Mariner Books, January 5, 2011.
  23. Bogleheads® forum topic: Rental Property Pros/Cons, December 29, 2014
  24. William J. Bernstein, The Four Pillars of Investing, McGraw-Hill, 2010.
  25. "Time value of money: Future value of a present sum, Wikipedia, retrieved August 4, 2016.
  26. Gerald Perrins and Diane Nilsen, "Math calculations to better utilize CPI data", Bureau of Labor Statistics, retrieved August 2, 2016.
  27. Automatic Determinations, Office of the Chief Actuary, retrieved August 2, 2016.
  28. Overview of BLS Statistics on Inflation and Prices, retrieved July 31, 2016.
  29. Kenneth J. Stewart and Joseph Pavalone, "Attachment F: Experimental CPI for Americans 62 Years of Age and Older", U.S. Bureau of Labor Statistics, December 3, 1996.
  30. "Consumer Price Index for the elderly", Bureau of Labor Statistics, March 2, 2012.
  31. "United States Chained Consumer Price Index", Wikipedia, retrieved August 2, 2016.
  32. Frequently Asked Questions about the Chained Consumer Price Index for All Urban Consumers (C-CPI-U), Bureau of Labor Statistics, retrieved August 4, 2016.
  33. Adam Zoll, "Don't Discount Inflation When Planning for Retirement", September 10, 2012.

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