Trying to Understand the Effect of Inflation

bigbigmamamoo

I am trying to understand the effect of inflation on two pension options. My pension is index-linked
Option 1: Maximum Lump sum, minimum annual pension
Option 2: Minimum Lump sum, maximum annual pension

I am considering taking the maximum lump sum because this would cover my mortgage and allow me to avoid paying interest

I have given myself a life expectancy of 30 more years and calculated the total income I would receive under assumptions of 0, 3%, and 5% annual increases in my pension

I can then calculate the difference between the two options factoring in the different lump sums and the fact that I would pay no interest under Option 1. However, I can't really get a feel for what the numbers mean.

For example, assuming 5% increases for 30 years I am better off taking Option 1, by £91k. However, I would only get 5% annual increases if CPI was running at 5%, so 91k would be worth less than what it is worth now, but how do I know how much it is worth in todays terms?

Is there a formula to convert it back to todays money?

bilbo51

Wel, if your cost of living index (CPI in your case if you pay off the mortgage) is the same as your pension index (CPI) you may as well calculate everything in today's terms, since one will cancel out the other...

bigbigmamamoo

bilbo51 wrote: »

Wel, if your cost of living index (CPI in your case if you pay off the mortgage) is the same as your pension index (CPI) you may as well calculate everything in today's terms, since one will cancel out the other...

that is what I thought, but where I am getting confused is how to figure in the mortgage cost. If I take the maximum lump sum I have a fixed figure for the cost of paying off my mortgage. There is no interest and no inflation on the cost of buying my flat. If I take the minimum lump sum, I will continue making mortgage payments and my interest is fixed for 7 more years, but I have a term of 13 years. I can calculate the total cost of paying off my mortgage based on my current interest rate, which will be the actual rate for the next 7 years, but I'm confused about the 6 years after that.

bilbo51

I think you need to make a guestimate of what you think the interest rate is going to be for the final 6 years of your mortgage. If you knew that, you'd be able to do the sums.

I'm afraid that my own crystal ball is a little cloudy...

bigbigmamamoo

bilbo51 wrote: »

I think you need to make a guestimate of what you think the interest rate is going to be for the final 6 years of your mortgage. If you knew that, you'd be able to do the sums.

I'm afraid that my own crystal ball is a little cloudy...

well I can pick a number and do the sums, and then pick another number and do the sums again

for some interest rates, if I then use zero inflation, Option 1 brings in the most money overall, when I subtract out the cost of buying my flat

but with 3% or 5% inflation, Option 2 wins, but I can understand by how much it wins since it is in an amount that has been inflated

wotsthat

Is there a formula to convert it back to todays money?

In Google spreadsheets and presumably in MS Excel as well the calculation is

=future value x POWER ((1.0 minus inflation), number of years into future)

Loughton_Monkey

wotsthat wrote: »

In Google spreadsheets and presumably in MS Excel as well the calculation is

=future value x POWER ((1.0 minus inflation), number of years into future)

In Excel, if you wanted to deflate, say, £20K by, say, 5% inflation for, say, 15 years, the formula would be

20000/(1.05)^15

If you wanted to inflate £20K going forward at 5% for 15 years, just use multiply instead of divide.

Loughton_Monkey

Sorry to complicate matters a bit more, but 'giving yourself 30 years' may well be giving you a false reading.

You see behind the pension figures you have been quoted, they will have calculated them using "standard" mortality for your age (whatever that is). If you use a different mortality, then by definition the results are going to be 'wrong'. The 'direction' of your findings (i.e. which option is best) may well still be correct, but the amount may not.

If you divide the difference in annual pensions, by the difference in lump sums, it should give you the assumed "Annuity Rate".

If you are anything like 60 years old, you will find it in the order of 6%? Possibly + or - 1%.

Now within that annuity rate, is an assumption of (a) how long you will live, and (b) what interest rate they can get on money. You cannot tell what either of those assumptions are, but by using standard mortality, you can do a calculation on excel, using 'goal seek' to establish roughly the interest rate they have assumed.

Whenever I have done this, I have come up with rather a low answer - in the order of 2% to 3%. The implication of this is if you can achieve better than this - over your life expectancy, then the higher lump sum will always look better. Paying off your mortgage is, in effect, investing it at whatever your mortgage rate is. [Remembering that paying off your mortgage, at, say, 4%, is equivalent to receiving 4% NET.]

The downside of this logic applies to those who outlive average mortality. This 'half' of the retiring people would theoretically tend to regret having taken the lump sum, more so the longer they live.

You can reach the official mortality tables via the link below.

http://www.statistics.gov.uk/StatBase/Product.asp?vlnk=14459

lordhaldon

Rule of 72 works for me. 72 divided your gestimeate of inflation rate OR interest rate gives you the period in years it will take money to half or double. Example, if interest rates are 5%. 72 divided by 5 =14.4 Therefore if you had say £100k in the bank at 5% interest rate, it would take 14.4 years before it became £200k.

If inflation is 5% it will take 14.4 years for £100k to become worth the equivalent of £50k in todays terms. (Assuming no interest payments) This helps you roughly work out how much your pension will buy in x years.:beer:

Hope this helps.