Friday, November 19, 2004

Inflation is the early retiree’s biggest enemy

As time goes, the cost of living increases. Actually, this is not really true: prices are increasing, but wages generally increases at the same rate or, hopefully, at a higher rate (when this occurs in a society, it is getting richer).

As prices are increasing, you will need to withdraw more money from your portfolio after retirement. How much more? It is difficult to tell. It depends upon many factors: health of the economy, interest rates, natural disasters, international events, etc.

Year to year, indexes permit the assessment of the increase of the cost of living: these are averages taking into account a basket of goods and services. The most common one is the CPI: the Consumer Price Index. Typically, in the US and in Canada, the CPI increase between 2-3% each year.

However, be aware that this CPI is for a basket of goods and services that does not reflect your own expenses. For instance, the CPI is calculated using many components that are weighted to reflect their relative importance. Thus, food price weighs more in the CPI than travel fares. For instance, in this document: http://www.bls.gov/cpi/cpiri2003.pdf, each CPI’s component is provided along with their weight in the index for many US cities.

How to deal with inflation in your retirement plan
To plan how much money you need to save in order to retire, you need to take inflation into account. Most calculators suggest entering an average value for inflation (say 3%). Thus, each year, you would withdraw 3% more than the previous year.

However, the real inflation that is relevant for you is the annual increase of your budget. It doesn’t matter if, for instance, cigarettes price has increased 10% that year if you don’t smoke.

Personal inflation assessment technique #1
To assess how much prices have increased *for you*, I think the best way is to compare your actual budget with that of the previous year. There are two components in your budget changes:

· Inflation (same items or services cost more than before)
· Increase or decrease in expenses (for instance, you travel more than before).

While you don’t have any control over inflation, you have some control over your expenses. Thus, try to make sure that your budget doesn’t increase more than what you planned in terms of inflation.

Personal inflation assessment technique #2
Technique #1 has some benefits: it really takes into account the increase of your expenses from one year to another. However, it has a major drawback: your budget may be quite different year to year for many reasons. For instance, you may have to replace your old car. You may also have some home repairs. For this reason, I think that you should also use the CPI. For instance, if a given year the CPI has increased 3% from the previous year and that your budget has increased 4%, you can estimate that you spent an additional 1% “new money” that year. If it is the case and if you planned a lower increase in your retirement plan, you’ll need to make some adjustments the following year.

The best estimate of your personal inflation would be to split your budget into CPI components, along with their respective weights in your budget and to calculate your own CPI based on the data provided by the government for each component. Thus, if electricity makes 5% of your budget, you will be able to reflect the inflation for this component into your budget. The overall CPI provided by the government is a much more general measure which might not reflect your consumption habits. However, doing that is quite complicated and you need to be much disciplined to use it. At least, if you use the official CPI, use the figure for your geographical area.

Bottom line
Inflation should be taken into account in your ER plan. Actually, it is the most important pitfall that could break down your plan. If some year your expenses increase faster than what was planned, make adjustments (remember, you don’t have control over inflation, but you do over your expenses).

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