One of the most essential components of any financial plan is the inflation rate. We hear about it so often in the news that it is often taken for granted, or glossed over a bit when planning, but it's impact on a long-term plan can not be overstated. While the actual rate fluctuates gradually from month to month, year over year changes can be more significant, and both will affect monthly and yearly expenses. While you can't accurately predict an annual outcome (much like not being able to predict stock market returns), the best way to incorporate inflation into a financial plan is to use historical results to arrive at a reasonable annual average. The current 20 year historical rate is approximately 2.55%. Of course, there have been years when the inflation rate was much greater (such as 8% inflation in 2022 and the current inflation rate of ~3.75%), but unusually high inflation rates are typically temporary, lasting one to three years,
so they can be accounted for in a longer-term average. To build a small margin of error into your plan, using an inflation rate of ~ 2.7% might be a good starting point. Many advisors suggest using a rate of 3% for the same reason.
Not a bad idea, but keep in mind that some expenses have more inflationary pressure than others. For example, certain categories of Health Care (e.g., insurance premiums, prescriptions, co-pays, etc.) seem to maintain a higher rate of inflation than general expenses (e.g., food, housing/rent, apparel, etc.). This is why The Complete Retirement Planner allows you to enter a separate (i.e. higher) inflation rate for those expenses. Utilizing a health care inflation rate in addition to a general inflation rate could potentially raise the total inflation rate of a plan above the 2.7% suggested above, getting closer to a single 3% rate suggested by advisors. The added benefit of using two separate rates is that
it will help to apply the rates to specific expenses more precisely.
How much of a difference does an inflation rate really make in the grand scheme of things? The short answer - it can make a tremendous difference. It also provides a terrific way to stress test your financial plan. It's always best to be conservative when you can't reliably predict what will happen in the future - you want to protect yourself in the event of an unexpected result, but you also want to keep in mind that your intent is to average a realistic rate over a long period of time, not to reflect or emphasize a few outlier years. You don't need to go to extremes. If 2.7% is a starting point,
and your plan results (at age 90, for example) look solid, then try raising the rate by ~.25% to add an additional margin of error. Still okay? Raise it another .25%, and that should provide a very healthy margin of error. But using a rate of 4% (especially over several decades), for example, would be considered excessive. In the 30 years prior to 2022, there was only one instance of inflation averaging more than 3% for any 5 year period. Be careful to see the forest for the trees.
It's also important to remember that not all expenses rise at the rate of inflation, and some might not rise at all.
For example, a fixed rate mortgage payment will not change from year to year, and that could easily represent
25% - 33% of total expenses. If your expenses are $100,000/year, with your mortgage being $27,000 of that total ($2,250/month), and inflation rises by .25%, your expenses for the next year would not rise by $2,500 ($100,000 x .25%). The increase would be closer to $1,825 since the mortgage does not adjust with inflation. Auto loan and
other fixed rate loan payments also do not increase with inflation. You may not have a mortgage or loan payments
in retirement, but the point is still valid, not all expenses are uniformly affected by inflation.
Of course, in retirement, inflation not only affects actual expenses, but it can also affect the amount needed to withdraw from tax deferred retirement savings to pay those expenses. Increasing expenses can lead to larger withdrawals, which can lead to higher taxes. For a typical retirement period of 25 years, depending on expenses and needed withdrawals from retirement savings, a .25% rate increase could easily cost an additional ~$200,000, or more. Put another way, each .25% increase in the applied inflation rate could represent an additional 8%-10% increase in total expenses. Using too high of an inflation rate in a plan runs the risk of trying to save much more than may be needed, and vice versa. Individual circumstances will ultimately decide how much of a difference the rate makes, but a small difference in the rate can certainly have a significant impact on retirement savings goals (and how long those savings may last).
Once you can see the extent of the impact on your results, it will be easier to decide what action to take, if any. Using an adequate inflation rate (General and Health Care) to try to account for ever-increasing expenses is an integral part of any retirement plan, and it should not be underestimated. Expect what seems to be historically reasonable, but be prepared for something worse. This is yet another good reason to choose a retirement planning tool that's capable of accurately calculating which of your expenses are subject to inflation (and which are not), and that offers the flexibility, detail, and clarity to help with this process.