Retirement Planner - Importance of Inflation?

OldMusicGuy

Agree with Alan above. I apply inflation to our expenditure. Forecast growth of investments is just that. Also, we can control expenditure and thus our personal inflation rate. But I model the impact of inflation separately from potential investment growth rates. 

GSP

OldMusicGuy said:

Agree with Alan above. I apply inflation to our expenditure. Forecast growth of investments is just that. Also, we can control expenditure and thus our personal inflation rate. But I model the impact of inflation separately from potential investment growth rates. 

Thanks OMG. Think Alan is talking about applying inflation to investments though?
As you say, you can see and control inflation within your own spending. By applying 2% within your fund calculations people are talking about differences of hundreds of pounds to tens of thousands of pounds. I am sure inflation does not affect our spending by tens of thousands of pounds every year. That’s why I think inflation should never be used in growth of fund calculations.

AlanP_2

So what do you propose to use for investment growth?

 

[Deleted User]

Look, there are 2 ways of addressing inflation:

1. Project the value of your fund in nominal terms. Thats today’s value plus nominal growth, including inflation. Then you need to apply inflation adjustment to your state pension. And then you need to apply inflation adjustments to your expenditure.

 So, if you have a million today, 7% nominal growth per year over 10 years, 7% annual inflation, no withdrawals, then you have 2m in nominal terms. However in 10 years you need to buy a house. House inflation was 7%/year. The house you wanted to buy costs 1m today. In 10 years time it will cost 2m. So you can buy the exact same house and there will be no cash left even though nominally you will have twice as much money before the purchase. In real terms your asset value has not changed.

2. The other, also correct approach, is to count everything in todays dollars.  

Then in 10 years time you will have 1m (nominal growth offset by inflation)  and the house will cost 1m. You are left with nothing after buying the house. Same outcome.

3. What you can’t do is mix and match to make yourself feel better. 

You are saying, “I will be a lot richer if I apply nominal growth rate to the funds I do not withdraw and ignore inflation”.  No you won’t. Your money is still worth the exact same amount when measured in houses you can buy. You are worth the same. There was zero growth in real terms over the 10 year period.

You can’t subtract withdrawal in real terms from inflated nominal fund value when calculating “growth”.  Apples and pears.  Yes, the difference between inflated fund value and real withdrawal value is a larger number, but its completly meaningless. Like subtracting value in kgs from value in lbs.  

Nu? 

GSP

AlanP_2 said:

So what do you propose to use for investment growth?

 

Growth or reduction in the overall fund balance, that’s it.

AlanP_2

GSP said:

AlanP_2 said:

So what do you propose to use for investment growth?

 

Growth or reduction in the overall fund balance, that’s it.

OK, so what are you forecasting for that over an extended period?

GSP

Deleted_User said:

Look, there are 2 ways of addressing inflation:

1. Project the value of your fund in nominal terms. Thats today’s value plus nominal growth, including inflation. Then you need to apply inflation adjustment to your state pension. And then you need to apply inflation adjustments to your expenditure.

 So, if you have a million today, 7% nominal growth per year over 10 years, 7% annual inflation, no withdrawals, then you have 2m in nominal terms. However in 10 years you need to buy a house. House inflation was 7%/year. The house you wanted to buy costs 1m today. In 10 years time it will cost 2m. So you can buy the exact same house and you will be penniless even though nominally you will have twice as much money. In real terms your asset value has not changed.

2. The other, also correct approach, is to count everything in todays dollars.  

Then in 10 years time you will have 1m (nominal growth offset by inflation)  and the house will cost 1m. You are left with nothing after buying the house. Same outcome.

3. What you can’t do is mix and match to make yourself feel better. 

You are saying, “I will be a lot richer if I apply nominal growth rate to the funds I do not withdraw and ignore inflation”.  No you won’t. Your money is still worth the exact same amount when measured in houses you can buy. You are worth the same. 

You can’t subtract withdrawal in real terms from inflated nominal fund value when calculating “growth”.  Apples and pears.  Yes, the difference between inflated fund value and real withdrawal value is a larger number, but its completly meaningless. Like subtracting value in kgs from value in lbs.  

Nu? 

3. There’s nothing about feeling better with 3. It’s a simple way and each metric is applied accordingly.
Fund - It grows and falls. You can determine your withdrawal on the health of your funds.
Withdrawal - You can plan to take out a certain amount depending on fund health. When you actually look at those household bills, the spending you have to make it’s probably half of your withdrawal and affected by inflation. So something like £360 a year. The rest is casual spend on holidays and everything else you want to which can be reined in at any time.
Why apply 2% inflation to your fund (tens of thousands of pounds), while in reality it’s a few hundred quid?

GSP

AlanP_2 said:

GSP said:

AlanP_2 said:

So what do you propose to use for investment growth?

 

Growth or reduction in the overall fund balance, that’s it.

OK, so what are you forecasting for that over an extended period?

3% a year.

[Deleted User]

“ Why apply 2% inflation to your fund (tens of thousands of pounds), while in reality it’s a few hundred quid? ”

In my case its well over 20k per year. And it compounds. 22% delta after 10 years. I could be retired for 40 years. Thats an awful lot to ignore. I have  no desire to keep my head in the sand. 

[Deleted User]

“When you actually look at those household bills, the spending you have to make it’s probably half of your withdrawal and affected by inflation. So something like £360 a year. The rest is casual spend on holidays”.

All of it is affected by inflation. Some of it is discretionary. Not relevant to the question about calculating the impact of inflation on your pension’s growth rate.