As financial planners, a lot of the work we do involves looking ahead to the future and making assumptions for things like returns on various types and classes of investments, implications of changes in the tax code, and the impact of inflation on future client expenses.
The quality of assumptions made for these factors can have a huge impact on the quality and usefulness of a financial plan.
Inflation over most of the past two decades has been low, running under 2%, so the recent dramatic increase in inflation took many by surprise.
There are several reasons for the recent rise in inflation. The recovery of the global (goods) supply chain following the covid shutdowns has been slower than expected. The war in Ukraine has resulted in supply reductions in both the global oil and food supply chains.
Another factor has been the high growth in the U.S. money supply over the past two years driven by both large government stimulus programs and monetary easing by the Federal Reserve, both of which were done to support recovery from COVID.
Assumptions about inflation are an important element in constructing a financial plan as inflation impacts client costs for living expenses, income streams like Social Security, and also expected returns on investments. In incorporating assumptions for inflation in a financial plan, some planners use trailing inflation data while others may use forecasts for future rates of inflation. We think trying to make forecasts for inflation is quite difficult, so we use the 50-year trailing annual rate of inflation. We believe this number is real, measurable, and grounded in actual data (it is currently 3.9% by the way).
But what about a time like the present, where inflation has gone up dramatically? It might be tempting to assume inflation will remain at 8%, but a reasonable analysis would most likely lead to the conclusion that it will not. So to use 8% as a long-term inflation rate in a financial plan would seem imprudent as it could dramatically overstate a client’s future expenses, and perhaps income as well. Additionally, how would one actually forecast inflation for the next 30, 40 or 50 years? It would be virtually impossible.
Ultimately the future inflation rate assumption is based on both historical data and the reasoned decision that because we really can’t forecast inflation, a number based on reality (i.e. actual historical data), is probably a more optimal choice and would also entail the least risk. The “risk” would be using a number which is so far from a reasonable assumption that it would significantly degrade the value of the plan. The same goes for investment return assumptions: using irresponsible return projections can do a great deal of damage in financial plan.As planners, a big part of our job is doing the analysis of both historic and current data to make projections that are well thought out, reasonable, and reduce risk in the plan as much as possible.
Robert Toomey, CFA/CFP, is Vice President of Research for S. R. Schill & Associates on Mercer Island.
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