We’ve all seen the headline number for 2021: a 7% increase in the consumer price index. You may be wondering: how does this affect my financial plan? Whether you have firsthand experience from the 1970s and early 1980s or have read about it in history books, the potential of sustained high inflation is cause for concern in a financial plan.
There are three important numbers in a financial plan when considering inflation:
- how much inflation is projected
- how much investment return is projected
- the real rate of return — the difference between inflation and the investment return
In our financial plans, we project 2.25% for long-term inflation for general expenses. For healthcare, we use 5.05%. For the investment returns, we project returns far lower than historical averages going forward. This approach results in investment projected returns depending on the asset allocation between 4% and 7%*. That means that the projected real rate of return in the financial plan is between 1.75% and 4.75% for general expenses.
To achieve that real rate of return in 2021, you had to earn inflation (7%) plus the real rate of return (1.75% – 4.75%). So, for your financial plan to stay on track, you needed to earn a total of 8.75% – 11.75%. Where in that range depends on your target asset allocation in your financial plan. If you look at your investment returns for 2021, you may be pleasantly surprised to discover that you exceeded the projected level in your plan.
Two other important inflation considerations
Our financial plans are tested with 1,000 different trials in a Monte Carlo simulation. We expect there to be some bad years in the investment markets where you potentially don’t stay ahead of inflation. Because of this rigorous testing, it’s still possible for your plan to be on track even during multi-year periods of high inflation combined with poor investment returns (the perfect storm).
If a big portion of your financial plan is a pension without cost-of-living adjustments, your plan will be more sensitive to inflation. For that reason, it’s important for teachers and other pension recipients to have savings outside their guaranteed pension payments. These additional savings can help keep up with inflation when your pension is losing purchasing power.
*Projected rates of returns are for planning purposes only and are never guaranteed.