Making sure the inflation assumption is correct in your financial planning models.
Financial planners are often asked two very simple questions:
- Am I saving enough towards my retirement?
- And are my retirement savings enough?
While these may seem simple enough and can easily be answered by a cleverly constructed spreadsheet utilizing detailed mathematical formulas, often the assumptions you use could significantly alter your answer in either a positive and/or negative way. Part of our role as financial planners is to ensure that clients are realistic about both investment returns and inflation rates. Part of what we are in the business of is expectations management.
In answering the two questions above, we need to look at your pre-retirement investment objectives and then your post-retirement income requirements. On either side of retirement, it is imperative that your portfolio produces a real return, which can be described as your investment return less the rate of inflation. The real return profile is ultimately the deciding factor as to whether you will be able to retire comfortably or not.
When constructing your investment portfolio, it is important to note that inflation levels that affect us now are not necessarily going to be the same in the future. One way of determining this is by using implied break even inflation over both the short term and long term versus your investment portfolio return.
Source: NFB Asset Management
The graph shows the difference between short term and long term implied breakeven inflation (IBI) (top graph) and current inflation. The long term IBI averages expected annual inflation forward to 2025 and comes in at 7.23% versus current inflation at 6.27%, while the market is pricing in inflation at 6.35% over the next 12 months which is very similar to the latest reported inflation figures released yesterday.
Whilst there is only a difference of under 1% between current and future inflation rates; the compounding effect of this must not be ignored. Particularly as retirement is often a long way away and for a long period of time; providing plenty of opportunity for these differences to compound themselves.
When building long term financial planning models clients should be realistic on both return assumptions and should utilise factual data when considering inflation assumptions. This should give you higher chance of meeting your retirement goals as it will either lead to saving more or drawing less, if necessary.