Retirement Planner - Importance of Inflation?

GSP

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

Some people use less money later on. Some more.  

Subtracting inflation from the assumed growth and assuming you will be spending  today’s pounds makes sense to me. Easier to count costs as we know them now. You are always free to change the assumptions if you disagree. 

Thanks. So if your fund was £750k and grew 3%, that’s £22.5k. If you calculate 2% inflation on withdrawal of £36k, that’s £720.
£22,500 less £720 = £21,780 growth.
This compares to 3% growth less 2% inflation = 1% ‘real return”.
1% of £750k = £7,500.
Quite a different outcome when you apply inflation to withdrawals only, rather than combining with growth?

Yes, it is different. Your first approach is wrong. The second one is correct. Hence the difference. 

You cant apply inflation to one part of what you own but not the other. A pound is a pound, it inflates whether  you withdraw or not. 

Sorry, I still can’t get my head round this. 

Surely inflation would only become an issue to the money I withdraw. The money in the fund itself just grows or shrinks depending on how the investments are performing?

Yes, the fund “just growth or shrinks“. If you want to know by how much, you need to account for inflation.

Say, your fund grows at the gross rate of 7%/year (nominal). And inflation is 7%/year. No withdrawals. In 10 tears the nominal value of your fund went up by a factor of 2. Sounds great, right? But you don’t actually care about the number of bills in your pocket. You care about the purchasing power. How many dinners, cars, holidays can you buy with the money? That hasn’t changed. The real value stayed the same as 10 years ago. 

Sorry.
Using your %’s for 1 year.
£750k fund grows 7% in one year = £52,500.
£36k withdrawals with 7% = £2,520.
I see a difference there of £49,980.

Combining 7% growth with 7% inflation = zero growth?

Yes, nominally it grows. In real terms you have zero growth. You can’t compare nominal growth with growth in real terms (net of inflation). Apples and pears. 

Or.
£750k fund growth of 7% = £52,500 + £750k = £802,500.
Less £36k withdrawal = £766,500.
So even with withdrawal, pot has grown £16,500 from the £750k.

7% inflation of withdrawal is £2,520.
I am still finding it hard to see how 7% growth of the fund (£750k) is wiped out by 7% inflation on withdrawals (£36k; inflation £2,520).

[Deleted User]

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

Some people use less money later on. Some more.  

Subtracting inflation from the assumed growth and assuming you will be spending  today’s pounds makes sense to me. Easier to count costs as we know them now. You are always free to change the assumptions if you disagree. 

Thanks. So if your fund was £750k and grew 3%, that’s £22.5k. If you calculate 2% inflation on withdrawal of £36k, that’s £720.
£22,500 less £720 = £21,780 growth.
This compares to 3% growth less 2% inflation = 1% ‘real return”.
1% of £750k = £7,500.
Quite a different outcome when you apply inflation to withdrawals only, rather than combining with growth?

Yes, it is different. Your first approach is wrong. The second one is correct. Hence the difference. 

You cant apply inflation to one part of what you own but not the other. A pound is a pound, it inflates whether  you withdraw or not. 

Sorry, I still can’t get my head round this. 

Surely inflation would only become an issue to the money I withdraw. The money in the fund itself just grows or shrinks depending on how the investments are performing?

Yes, the fund “just growth or shrinks“. If you want to know by how much, you need to account for inflation.

Say, your fund grows at the gross rate of 7%/year (nominal). And inflation is 7%/year. No withdrawals. In 10 tears the nominal value of your fund went up by a factor of 2. Sounds great, right? But you don’t actually care about the number of bills in your pocket. You care about the purchasing power. How many dinners, cars, holidays can you buy with the money? That hasn’t changed. The real value stayed the same as 10 years ago. 

Sorry.
Using your %’s for 1 year.
£750k fund grows 7% in one year = £52,500.
£36k withdrawals with 7% = £2,520.
I see a difference there of £49,980.

Combining 7% growth with 7% inflation = zero growth?

Yes, nominally it grows. In real terms you have zero growth. You can’t compare nominal growth with growth in real terms (net of inflation). Apples and pears. 

Or.
£750k fund growth of 7% = £52,500 + £750k = £802,500.
Less £36k withdrawal = £766,500.
So even with withdrawal, pot has grown £16,500 from the £750k.

7% inflation of withdrawal is £2,520.
I am still finding it hard to see how 7% growth of the fund (£750k) is wiped out by 7% inflation on withdrawals (£36k; inflation £2,520).

That’s because inflation does’t selectively apply to withdrawals. Every quid drops real value whether you decide to withdraw or not. 

Try another thought experiment. Zero % withdrawal. Zero growth. 7% inflation. In 10 years nominal value is the same as your original value. Your purchasing ability halved. The value of your fund halved. Even though numerically you still have the exact same number of pounds. So your growth is zero in nominal terms but minus 50% in real terms. Zero does not equal -50%. Nor should it. Apples and pears. 

Sea_Shell

Interesting discussion.

I think I too fallen foul of the "not applying the effect of inflation on the funds still invested" trap!!

In that I apply a growth rate to the fund, and an inflation rate to the spends, but i see now that this is not going to give me a "real terms" value of the pot in years to come.

Do I need to project then the "net" growth, in my chart, of the gross growth, less inflation.

So if i hope to be able to withdraw 3% from my pot each year, i need this to be an "after" inflation figure?

EG real growth of 5% with 2% inflation???

ukdw

GSP said:

ukdw said:

Personally I find it less confusing to work in absolute terms.
My current cash flow planner spreadsheet is mainly absolute figures, with average annual growth rate of 5% for pensions and ISAs and 1.5% for cash.

I assume 2.5% growth for the state pensions, plus 5.8% on top of that for deferred years.  

I assume the up to age 75 minimum pension contribution limit stays at 3,600 - so the annual tax relief benefit stays at £720.
I assume the basic rate income tax rate stay at 20%, with the bands increasing inline with average 2.5% inflation. 

I assume spending increases by 2.5% annually for the first and last period of retirement, with spending in the middle years being flat.
I project out to age 99 - but focus most attention on average lifespan of age 84.
I do have a few extra columns that are back calculated into real terms values mainly as a sense check.

Thanks. So would you apply inflation to your withdrawals only?

I apply projected inflation to my spending and tax bands only.  You could argue the 5% and 1.5% growth projections I use also include inflation (so are 2.5% and -1%).    I've tried it both ways and you come out with similar results  - I just personally prefer using absolute values as I find real values more confusing.

This was particularly the case prior to retirement when I was working out the total amount I needed to save in order to be financially able to retire.   Using absolute values gave a definitive savings target to aim for, with real values the savings target is more confusing in my opinion.

cfw1994

Well, my thoughts are this:
I apply inflation to my “desired-income”, along with the anticipated growth rates for any State Pension plus any DB pots (maybe CPI, RPI or some other figure).

For the DC pot, you don’t have to add inflation to the anticipated growth, just be aware that when you (for example) take £12k out one year to go towards your desired-income, it was that desired-income that DID have inflation applied.   That is the important bit.

The fact that the DC pot doesn’t explicitly show an “inflation adjusted” value doesn’t really matter, in my view.  It is “just” a pot you are drawing on to meet your inflation-adjusted desired income, and will go up (or down) depending on the investments.  

The amount of growth (or loss) is the tricky variable, as I see things.....and that is the % I try to “stress test” scenarios into....

Not sure if that sounds clear enough?

GSP

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

GSP said:

Deleted_User said:

Some people use less money later on. Some more.  

Subtracting inflation from the assumed growth and assuming you will be spending  today’s pounds makes sense to me. Easier to count costs as we know them now. You are always free to change the assumptions if you disagree. 

Thanks. So if your fund was £750k and grew 3%, that’s £22.5k. If you calculate 2% inflation on withdrawal of £36k, that’s £720.
£22,500 less £720 = £21,780 growth.
This compares to 3% growth less 2% inflation = 1% ‘real return”.
1% of £750k = £7,500.
Quite a different outcome when you apply inflation to withdrawals only, rather than combining with growth?

Yes, it is different. Your first approach is wrong. The second one is correct. Hence the difference. 

You cant apply inflation to one part of what you own but not the other. A pound is a pound, it inflates whether  you withdraw or not. 

Sorry, I still can’t get my head round this. 

Surely inflation would only become an issue to the money I withdraw. The money in the fund itself just grows or shrinks depending on how the investments are performing?

Yes, the fund “just growth or shrinks“. If you want to know by how much, you need to account for inflation.

Say, your fund grows at the gross rate of 7%/year (nominal). And inflation is 7%/year. No withdrawals. In 10 tears the nominal value of your fund went up by a factor of 2. Sounds great, right? But you don’t actually care about the number of bills in your pocket. You care about the purchasing power. How many dinners, cars, holidays can you buy with the money? That hasn’t changed. The real value stayed the same as 10 years ago. 

Sorry.
Using your %’s for 1 year.
£750k fund grows 7% in one year = £52,500.
£36k withdrawals with 7% = £2,520.
I see a difference there of £49,980.

Combining 7% growth with 7% inflation = zero growth?

Yes, nominally it grows. In real terms you have zero growth. You can’t compare nominal growth with growth in real terms (net of inflation). Apples and pears. 

Or.
£750k fund growth of 7% = £52,500 + £750k = £802,500.
Less £36k withdrawal = £766,500.
So even with withdrawal, pot has grown £16,500 from the £750k.

7% inflation of withdrawal is £2,520.
I am still finding it hard to see how 7% growth of the fund (£750k) is wiped out by 7% inflation on withdrawals (£36k; inflation £2,520).

That’s because inflation does’t selectively apply to withdrawals. Every quid drops real value whether you decide to withdraw or not. 

Try another thought experiment. Zero % withdrawal. Zero growth. 7% inflation. In 10 years nominal value is the same as your original value. Your purchasing ability halved. The value of your fund halved. Even though numerically you still have the exact same number of pounds. So your growth is zero in nominal terms but minus 50% in real terms. Zero does not equal -50%. Nor should it. Apples and pears. 

Sorry, all I can see is apples and pears when using growth and inflation together on the same number. Growth is your fund and a % of that would be much larger than a % of your withdrawal. 

When your money is withdrawn from the fund, then it’s at risk of inflation. Within your fund, all that can affect it are the daily up and down swings of your investments. There is no inflation while your money is still invested.

GSP

ukdw said:

GSP said:

ukdw said:

Personally I find it less confusing to work in absolute terms.
My current cash flow planner spreadsheet is mainly absolute figures, with average annual growth rate of 5% for pensions and ISAs and 1.5% for cash.

I assume 2.5% growth for the state pensions, plus 5.8% on top of that for deferred years.  

I assume the up to age 75 minimum pension contribution limit stays at 3,600 - so the annual tax relief benefit stays at £720.
I assume the basic rate income tax rate stay at 20%, with the bands increasing inline with average 2.5% inflation. 

I assume spending increases by 2.5% annually for the first and last period of retirement, with spending in the middle years being flat.
I project out to age 99 - but focus most attention on average lifespan of age 84.
I do have a few extra columns that are back calculated into real terms values mainly as a sense check.

Thanks. So would you apply inflation to your withdrawals only?

I apply projected inflation to my spending and tax bands only.  You could argue the 5% and 1.5% growth projections I use also include inflation (so are 2.5% and -1%).    I've tried it both ways and you come out with similar results  - I just personally prefer using absolute values as I find real values more confusing.

This was particularly the case prior to retirement when I was working out the total amount I needed to save in order to be financially able to retire.   Using absolute values gave a definitive savings target to aim for, with real values the savings target is more confusing in my opinion.

I agree with you. Different metrics carry different weightings and to start adding growth and inflation together and applying that to a number is not comparing apples with apples. By keeping all metrics separate, you can apply a % then bring that result into your calculated projections.

GSP

cfw1994 said:

Well, my thoughts are this:
I apply inflation to my “desired-income”, along with the anticipated growth rates for any State Pension plus any DB pots (maybe CPI, RPI or some other figure).

For the DC pot, you don’t have to add inflation to the anticipated growth, just be aware that when you (for example) take £12k out one year to go towards your desired-income, it was that desired-income that DID have inflation applied.   That is the important bit.

The fact that the DC pot doesn’t explicitly show an “inflation adjusted” value doesn’t really matter, in my view.  It is “just” a pot you are drawing on to meet your inflation-adjusted desired income, and will go up (or down) depending on the investments.  

The amount of growth (or loss) is the tricky variable, as I see things.....and that is the % I try to “stress test” scenarios into....

Not sure if that sounds clear enough?

Yes agree that you should be aware that inflation goes up a bit. Using 2% inflation on your withdrawals say of £36k is £720. Quite different to using 2% to your fund of £750k which is a £15k loss. Inflation does not account for £15k in one year, that’s how I see it anyway.

AlanP_2

But actual investment returns include inflation surely?

For example, inflation increases the price of your BT Broadband & TV package, which (assuming BT make a reasonably fixed %'age Nett Profit) will lead to higher reported profits down the line and thus in to Dividends and Share Price but the "value" to you of those £s has been reduced by the same inflation rate.

There'll be exceptions where particular investments make a real return over a period and some make a real loss as they fail to keep up with inflation but surely all that you are trying to achieve in your cashflow is an "average" or "indication" on how things could go over 10/20/30 years? You don't know whether your chosen investments will be in the former or the latter category.

In my cash flow I use Personal Expense Inflation of 4% applied to our projected spend, Cash Return of 1.5%, Investment Returns of 3% and CPI at 2.5% for DB / SP increases.

So I am planning on real returns of 0.5% from investments and a loss of -1% on cash.

If the plan looks like it will work with those assumptions then I'm happy as I wouldn't expect future returns to be as poor in reality.

GSP

AlanP_2 said:

But actual investment returns include inflation surely?

For example, inflation increases the price of your BT Broadband & TV package, which (assuming BT make a reasonably fixed %'age Nett Profit) will lead to higher reported profits down the line and thus in to Dividends and Share Price but the "value" to you of those £s has been reduced by the same inflation rate.

There'll be exceptions where particular investments make a real return over a period and some make a real loss as they fail to keep up with inflation but surely all that you are trying to achieve in your cashflow is an "average" or "indication" on how things could go over 10/20/30 years? You don't know whether your chosen investments will be in the former or the latter category.

In my cash flow I use Personal Expense Inflation of 4% applied to our projected spend, Cash Return of 1.5%, Investment Returns of 3% and CPI at 2.5% for DB / SP increases.

So I am planning on real returns of 0.5% from investments and a loss of -1% on cash.

If the plan looks like it will work with those assumptions then I'm happy as I wouldn't expect future returns to be as poor in reality.

In the fund, the overall figure is where you see real growth or loss and there are so many factors in there. Take that money out of fund and that’s where it becomes affected by inflation to pay bills etc.
To me, there are attempts to produce an inflation figure in funds themselves, where they are also visibly hit outside your fund in spending. Could be there is double counting for those using inflation in their fund calculations, only to be hit outside as well?