By George Chamberlin
One interesting aspect of planning for your clients’ future is how inflation plays into the overall financial plan and its results . This seemingly minor factor can have an enormous impact on the client’s confidence level and if misused can cause serious problems as time passes.
Most financial plans utilize what is termed a default inflation rate that is set at the outset of plan data entry. This rate is applied to all flows that occur in the future – incoming or outgoing – unless the planner manually adjusts the rate for a particular cash flow as a part of the planning process. So the first step to making the most of the inflation element in the plan is to know what your default rate is going to be and whether it fits in with both the advisor’s and the client’s expectations.
We used to see a lot of plans with a default of 3% annual inflation. Though inflation has been well below that rate for quite some time now, that rate is still a very common sight. Looking at a client’s retirement spending goal, that rate might make good sense. We know prices will ramp up over time and that the “official” inflation rate can be measured in many different ways. A default rate of 3% for retirement spending over time will provide reasonable assurance that the client’s purchasing power will keep up.
In some cases, the nature of a spending goal is such that assuming a default like 3% probably will not be enough. Good examples here include goals for higher education and for funding health care needs. Both of these areas tend to carry a rather higher rate of growth than what we would call default or standard inflation, especially when it is set at 3%. If one underestimates the actual rate of growth in the overall cost of a goal, planned funding will turn out to be insufficient when the client reaches the time to make distributions for that goal. Therefore, it is important to set the rate to what we consider an appropriate level to make sure we are keeping pace.
On the flip side, the issues and questions we face with handling inflows to the plan come at the inflation or growth rate from a different perspective. For example, we know that many pensions, for those who still receive them, are fixed and the payments do not inflate or grow over time. We manually adjust the flow in data entry to reflect that fact or we might be in trouble when the plan does not work out over time because less is coming in than we expected. Here’s a recent example where a client and advisor experienced that issue:
The plan was for a client nearing retirement and expecting to receive over $30,000 annually from Social Security. The plan used the default inflation – set at 3% – for this cash flow. But what has been the annual increase percentage for Social Security recipients in the past few years? We know, for example, that 2016 will have a 0% growth rate in the benefit. Changing the inflation assumption to a more conservative 1% had a large impact on the plan result – 11 points – and necessitated our toning down some of the client’s other spending goals. Better to know that now than realize the shortfall in a few years….
What we see at work here is the opposite concern from setting a proper retirement spending inflation rate. Though it may not be a bad idea to tend to slightly overstate the growth rate for outflows in the plan as long as we avoid certain sacrifice to the client, there is a larger danger lurking in overstating the growth of anticipated income in that the plan may turn out to be underfunded and the client may fail to achieve some of the valued goals. For a case that could have caused an advisor some liability issues, here’s another real life example:
The plan, for a California retiree, had a confidence level of 85 while allowing for the ideal spending goal. The primary asset in the plan, the client’s home, was properly reflected as a non-investment asset although the client intended to sell the property in retirement to meet goals. Unfortunately, the advisor, perhaps overconfident with the real estate market, earmarked the home’s growth rate between the present and a future sale at a mere 10% annually. The million dollar house, years down the road, was a great source of cash to fund the client’s goals. However, when we changed the inflation rate on the sale proceeds to 2%, the confidence level for the plan dropped almost to zero.
Overstating the growth rate for a future inflow undermines the confidence we strive for in putting together a client’s plan. Even if there is a small chance that one’s real property might appreciate at ten percent annually year over year, and ignoring the potential impact of taxes and other costs along with liquidity issues inherent in real property, a result at or about the fifth percentile of results simply is not defensible. We place the comfort zone at the seventy-fifth to ninetieth percentiles, giving us reasonable confidence that the plan will work even in poor markets. The quoted example did not do that and could have resulted in substantial liability for the planner. We do not want to take on that risk.
With these examples and the client’s own situation in mind, we should be better prepared to create a plan that thoughtfully incorporates inflation and growth rates in a manner consistent with reality as well as the client’s confidence and comfort. In some cases our job is easy, as where a pension has a stated, fixed COLA to be used. However, it is more often the case that we are in the position of guessing what the rate of inflation will be for a particular flow. If you are not sure what the right rate of inflation is for a specific goal, try one or more what if scenarios with different rates. If the plan result seems too good to be true, then that probably is not the rate to be using. Talk with your peers and find out what they are doing and how they think about using inflation in their plans.
1Our focus is on inflation as expressed in the plan cash flows, which we can control in data entry, and not inflation as an element of projected asset performance in the thousands of iterations of the plan.
2Take a look here for the history of Social Security COLA adjustments. You may find it surprising. Note that the COLA for 2015, omitted from the table, was 1.7%. http://www.ssa.gov/oact/cola/colaseries.html
George Chamberlin has been working in the legal and financial industry for over thirty years, including working at Wealthcare Capital Management from 2002-2009. George practiced law for several years before focusing on writing, planning and software development in the estate planning and financial planning areas. During his time at Wealthcare, George wrote weekly e-mails for advisors and their clients, engaged in basic and advanced financial planning and estate planning as well as working on a variety of other Wealthcare projects. Since 2009, George has worked as a registered investment adviser representative in his own firm, meeting and planning with clients, and more recently as a consultant to financial advisors, including Wealthcare advisors, on a variety of matters including advanced financial and estate planning.
George Chamberlin & Mentor RIA Consulting © 2015