Retirement Planner - Importance of Inflation?

GSP · 4 November 2020 at 1:02PM

Deleted_User said:

“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.

It’ll be interesting to hear from anyone who has been using growth less inflation to forecast their fund balance? I reckon by using a growth of 1% (3% growth less 2% inflation), they have ended up with far more money in their fund.

[Deleted User] · 4 November 2020 at 1:07PM

GSP said:

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.

Its about using nonsensical maths to make yourself feel better. The following has a basic error:
” 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.“

You are accounting for inflation in withdrawn cash when calculating growth, but not for inflation in remaining funds. Thats pounds and kilograms so your “growth” figure is completely meaningless.

GSP · 4 November 2020 at 1:21PM

Deleted_User said:

GSP said:

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.

Its about using nonsensical maths to make yourself feel better. The following has a basic error:
” 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.“
You are accounting for inflation in withdrawn cash when calculating growth, but not for inflation in remaining funds. Thats pounds and kilograms so your “growth” figure is completely meaningless.

Thanks Mordko. I understand the first portion, but not your last paragraph.
If you just left growth on fund to grow at 3% a year, it’s a far bigger number than applying 2% to household spending.

[Deleted User] · 4 November 2020 at 1:27PM

Exactly. Applying a nominal 3% growth on fund makes growth seem bigger. Its not real growth. If you really want to do it this way - fine but then don’t pretend that you somehow accounted for inflation. You didn’t.

And be consistent. Don’t subtract the value of inflation just on the withdrawals portion. You can either measure real growth net of inflation or nominal growth. Can’t mix.

[Deleted User] · 4 November 2020 at 1:41PM

Now... You may very well get 3% growth in real terms. Thats not an unreasonable assumption, just less pessimistic. I am just trying to explain the maths of inflation to answer your original question.

GSP · 4 November 2020 at 1:56PM

Deleted_User said:

Exactly. Applying a nominal 3% growth on fund makes growth seem bigger. Its not real growth. If you really want to do it this way - fine but then don’t pretend that you somehow accounted for inflation. You didn’t.

And be consistent. Don’t subtract the value of inflation just on the withdrawals portion. You can either measure real growth net of inflation or nominal growth. Can’t mix.

That’s the thing, I am not accounting for inflation. Withdrawals and spending can be adjusted all sorts of ways, but the key thing is the health of your fund.

[Deleted User] · 4 November 2020 at 2:06PM

GSP said:

Deleted_User said:

Exactly. Applying a nominal 3% growth on fund makes growth seem bigger. Its not real growth. If you really want to do it this way - fine but then don’t pretend that you somehow accounted for inflation. You didn’t.

And be consistent. Don’t subtract the value of inflation just on the withdrawals portion. You can either measure real growth net of inflation or nominal growth. Can’t mix.

That’s the thing, I am not accounting for inflation. Withdrawals and spending can be adjusted all sorts of ways, but the key thing is the health of your fund.

Well, your calculation of growth was wrong. Thats a fact. Maths. Statements like “health of you fund” are entirely subjective so thats up to you to judge.

snookered1 · 4 November 2020 at 2:35PM

Why add inflation into your projection at all?, it just makes the numbers look big and impressive, and you may end up kidding yourself as to how well you are doing, as the numbers may look great, but what will be the price of a pint of milk in 10 years ?

and general living costs.
In my opinion it confuses you as to if you really are on track, as you know what life costs you in todays money and for me that's the easiest and best way of working out if I'm on track.
What I do is take my assumed headline investment growth for example say 6% with investments (I'm always conservative), and subtract an assumed inflation rate from it e.g. 2.5%, (-1% for cash in the bank) so your pound invested in todays money is showing a projected real growth above inflation of for example 3.5% but the cash in the bank is actually shrinking, I plumb that into my spreadsheet and use as a reference annual fund real growth and compound this growth in my projections over a number of years, and tweak the "todays" amounts monthly.

GSP · 4 November 2020 at 3:01PM

snookered1 said:

Why add inflation into your projection at all?, it just makes the numbers look big and impressive, and you may end up kidding yourself as to how well you are doing, as the numbers may look great, but what will be the price of a pint of milk in 10 years ? and general living costs.
In my opinion it confuses you as to if you really are on track, as you know what life costs you in todays money and for me that's the easiest and best way of working out if I'm on track.
What I do is take my assumed headline investment growth for example say 6% with investments (I'm always conservative), and subtract an assumed inflation rate from it e.g. 2.5%, (-1% for cash in the bank) so your pound invested in todays money is showing a projected real growth above inflation of for example 3.5% but the cash in the bank is actually shrinking, I plumb that into my spreadsheet and use as a reference annual fund real growth and compound this growth in my projections over a number of years, and tweak the "todays" amounts monthly.

Thanks. Bit confused there at first, but can see your first bit was tongue in cheek about not including inflation. On the contrary, my projections show a shrinking pot until state pension kicks in and halts the slide somewhat.
I think this could be reviewed every few years to see the effect of inflation, and by then there will be different behaviours and perhaps other things into the equation.
Not sure I would want to keep revising it monthly however.