Retirement Planner - Importance of Inflation?

Stubod

My base assumption is my cash (or cash like) savings will keep their value against inflation. For equities I assume the same and add 4% which is around the long run real return.

..not sure why you would assume this as savings rates have been less than inflation for years? (Unless you are lucky enough to have all your cash in the good old NSI "index linked bonds"....(sighs...happy days)...

SouthCoastBoy

To add to the inflation debate. This is how I model it.
I have an inflation factor default 2.5% per year, retrospectively adjusted. 
Independently I have a growth rate for equities ,3% (real return 0.5%) and cash, 0.5% (real return -2%). I apply the growth rates to the pot.
The amount of money I withdraw each year is always entered in my base year (2017) and the inflation factor applied to get the actual amount needed, so in year I1 if I want to draw out £2000 per mth, in year 2 this would be £2050 per mth, year 3 £2101.25 per mth etc. 
I don't apply inflation to the state pension as I have made the assumption it will keep up with inflation, so for example if state pension is £600 per mth in 2017. it stays at £600, so in my example above I want total income of £2600 per mth in 2017 terms , in year 1 it is (£2000 + £600), year 2 (£2050 + £600), year 3 (£2101.25+£600). As I retrospectively apply inflation the year 3 figure (£2101.25) could go up or down.
I have a pot value in current year and 2017 prices, I project out to 90 years of age. 
I also apply 20% tax to income where applicable, i'm 50% in pension and 50% ISAs. I apply the yearly allowance at 2017 prices, so my end income is always calculated in 2017 prices and the appropriate inflation factor applied to get a monthly amount needed for withdrawal.

Notepad_Phil

Sailtheworld said:

Notepad_Phil said:

Sailtheworld said:

I have a fairly complicated retirement spreadsheet. I run tax year to tax year just to help drawdown projections.

All numbers are in today's money so for investment returns I assume 4% ahead of inflation for equities and 0% for gilts / cash. In terms of spending I have a figure in mind and review this once a year. All calculations based on today's tax / state pension / PCLS rules etc. I think it gives a better feel for whether it's enough if thinking about projected income if it's in today's money.

One of my spreadsheets is similar to this, however it seems that you don't account for the inflationary impact on savings or have I misread your post? e.g. my spreadsheet might multiply my savings by 0.99 every year for the first bunch of years as I'm a bit of a best interest rate seeker and so I'd hope that I was not too far behind inflation, but I have also done scenarios where I've dramatically raised the dampener to e.g. account for high inflation where interest rates have remained low (which might be where we're heading over the next few years, though I sincerely hope not).

My base assumption is my cash (or cash like) savings will keep their value against inflation. For equities I assume the same and add 4% which is around the long run real return. 

I think it's the same as what you're doing. You're saying something like you hope to get 1% interest on savings but you need to account for inflation of, say, 1% so you've matched inflation. I'm just dealing with this by saying real returns are zero. To simulate times when rates are low and inflation high I just turn down the real rate of return. I should probably have a negative real return for cash but I don't factor in a lot of cash and I just can't bring myself to do it.

Not quite, 0.99 is saying that I'm losing about 1% of my savings to inflation every year. Now it might be that inflation is 5% and I can get 4% for my savings, or that inflation is 3% and I can get 2% for my savings.
If you've only a small ratio of savings to the rest of your portfolio then it may not be as important for you, but for me I definitely want to recognise the inflationary impact on my savings.

Secret2ndAccount

The answer to your question GSP is yes, you HAVE to incorporate inflation and growth into your model. You can do it by tweaking down your rates of return, or by having separate calculations for growth and inflation, but your simulation can't be useful if you don't consider inflation. Doing your accounting with growth but no inflation would be like doing your accounting with salary but no bills.

Even 2% inflation over 35 years will cause prices to double. So your savings and investments need to double too, or you have to cut spending.

The holy grail is to have a portfolio that grows, beyond inflation, by enough to fund your liefestyle. So perhaps your funds grow 6% with inflation at 2%. You can take out the 4% difference and spend it, and that leaves the fund still just as valuable as before, even after taking inflation into account. This way you can live to be 1000 and you won't run out of money. Not easy to do as you need quite a large pot, and it's hard to substantially beat inflation every year.

cfw1994

Secret2ndAccount said:

The answer to your question GSP is yes, you HAVE to incorporate inflation and growth into your model. You can do it by tweaking down your rates of return, or by having separate calculations for growth and inflation, but your simulation can't be useful if you don't consider inflation. Doing your accounting with growth but no inflation would be like doing your accounting with salary but no bills.

Even 2% inflation over 35 years will cause prices to double. So your savings and investments need to double too, or you have to cut spending.

The holy grail is to have a portfolio that grows, beyond inflation, by enough to fund your liefestyle. So perhaps your funds grow 6% with inflation at 2%. You can take out the 4% difference and spend it, and that leaves the fund still just as valuable as before, even after taking inflation into account. This way you can live to be 1000 and you won't run out of money.  Not easy to do as you need quite a large pot, and it's hard to substantially beat inflation every year.

Not to mention it is also slightly tricky to keep the mind and body working particularly well after 90-100 years on Planet Earth 

Sea_Shell

Secret2ndAccount said:

The holy grail is to have a portfolio that grows, beyond inflation, by enough to fund your liefestyle. So perhaps your funds grow 6% with inflation at 2%. You can take out the 4% difference and spend it, and that leaves the fund still just as valuable as before, even after taking inflation into account. This way you can live to be 1000 and you won't run out of money. Not easy to do as you need quite a large pot, and it's hard to substantially beat inflation every year.

I agree, and that's what we're hoping to achieve, in part.  BUT, for us, its not a case of preserving the initial pot at it's current level (or worth in real terms) forever, as we have no direct descendants to benefit from any balance remaining.   

It's a balancing act of running it down, at a sustainable rate, to then complement additional DB and State Pensions in due course.

However, our natural spending pattern is a modest one, and we're currently only spending about 2% of our pot!!!

Linton

Rather than overspending in the early years and taking the risk that you will live too long spending years on the breadline it could be worth considering deferring your State Pension for some time. This will give you a higher inflation linked guaranteed income in old age than available from an annuity and will reduce the amount of unused wealth that you will probably leave on death.

Sailtheworld

Notepad_Phil said:

Sailtheworld said:

Notepad_Phil said:

Sailtheworld said:

I have a fairly complicated retirement spreadsheet. I run tax year to tax year just to help drawdown projections.

All numbers are in today's money so for investment returns I assume 4% ahead of inflation for equities and 0% for gilts / cash. In terms of spending I have a figure in mind and review this once a year. All calculations based on today's tax / state pension / PCLS rules etc. I think it gives a better feel for whether it's enough if thinking about projected income if it's in today's money.

One of my spreadsheets is similar to this, however it seems that you don't account for the inflationary impact on savings or have I misread your post? e.g. my spreadsheet might multiply my savings by 0.99 every year for the first bunch of years as I'm a bit of a best interest rate seeker and so I'd hope that I was not too far behind inflation, but I have also done scenarios where I've dramatically raised the dampener to e.g. account for high inflation where interest rates have remained low (which might be where we're heading over the next few years, though I sincerely hope not).

My base assumption is my cash (or cash like) savings will keep their value against inflation. For equities I assume the same and add 4% which is around the long run real return. 

I think it's the same as what you're doing. You're saying something like you hope to get 1% interest on savings but you need to account for inflation of, say, 1% so you've matched inflation. I'm just dealing with this by saying real returns are zero. To simulate times when rates are low and inflation high I just turn down the real rate of return. I should probably have a negative real return for cash but I don't factor in a lot of cash and I just can't bring myself to do it.

Not quite, 0.99 is saying that I'm losing about 1% of my savings to inflation every year. Now it might be that inflation is 5% and I can get 4% for my savings, or that inflation is 3% and I can get 2% for my savings.
If you've only a small ratio of savings to the rest of your portfolio then it may not be as important for you, but for me I definitely want to recognise the inflationary impact on my savings.

Oh I see. Yes I could assume minus 1% return on cash which would be more realistic but it offends me. It actually makes little difference because I'm quite a few years away from retirement so equity focused and the most cash like investment I have is VGOV which seems to perform ahead of inflation (it's been a funny year though). I avoid cash like the plague.

I'm hanging around here not to finesse what figure I should use for cash returns over the next four decades or so but to see how people deal with negative returns on cash. It seems to me that if the difference between 0% and -1% return on cash is significant there's an over exposure to cash. 

GSP

Secret2ndAccount said:

The answer to your question GSP is yes, you HAVE to incorporate inflation and growth into your model. You can do it by tweaking down your rates of return, or by having separate calculations for growth and inflation, but your simulation can't be useful if you don't consider inflation. Doing your accounting with growth but no inflation would be like doing your accounting with salary but no bills.

Even 2% inflation over 35 years will cause prices to double. So your savings and investments need to double too, or you have to cut spending.

The holy grail is to have a portfolio that grows, beyond inflation, by enough to fund your liefestyle. So perhaps your funds grow 6% with inflation at 2%. You can take out the 4% difference and spend it, and that leaves the fund still just as valuable as before, even after taking inflation into account. This way you can live to be 1000 and you won't run out of money. Not easy to do as you need quite a large pot, and it's hard to substantially beat inflation every year.

Thanks. That’s what I couldn’t my head round, why some put the growth and inflation calculation together, virtually wiping out the growth. I can see growth should be for your fund, inflation should be on your spending/withdrawal side. It must be easier to monitor the two metrics if kept separately, also making it easier to tweak if need be if converting to actuals from forecast.
Your second paragraph is very clear. Like taking the profit if you can when growth is good. That’s what I have been looking at a sort of timing withdrawals at the right time. My wife has been invested for just over 3 years, but won’t be able to drawdown until 2022. What this means is she has a clean run of data up to now. I have input all the daily data and it’s very interesting to see the wide range of positive and negative falls over time. It does seem possible however, if you can delay decisions for a few months to withdraw with good growth from your last withdrawal, thus leaving your pot intact.
What I need clarification on though does the time of withdrawal request lock in that growth. For e.g. you request your IFA to withdraw an amount, he instructs the provider the same day. I assume straight away meaning the next business day that request is turned into cash and the growth calculation locked in, with the money being credited to your bank account 1-2 weeks later depending. That’s my uncertain bit, making sure that decision to withdraw at the ‘right time’ isn’t at risk while the withdrawal transaction completes its process?

GSP

Linton said:

Rather than overspending in the early years and taking the risk that you will live too long spending years on the breadline it could be worth considering deferring your State Pension for some time. This will give you a higher inflation linked guaranteed income in old age than available from an annuity and will reduce the amount of unused wealth that you will probably leave on death.

Thanks. That’s certainly sounds like another option. Is there a table that shows how much more SP you get if you defer for a year, 3 years, 5 years etc. Makes you also think is it worthwhile losing out on that £10k at the time with your body clock ticking down?