We talked elsewhere about the worries of retirees of outliving their assets due to both growing average longevity and the significant individual longevity variability around that average, leading to the risk of significant longer retirements. The longer retirements in turn lead the requirement for larger asset pool at the start of retirement in order to have an acceptable risk of not running out of money. The asset pool that you start retirement with will likely have to be even higher due to significant evidence that inflation experienced by the elderly is higher (much higher in the U.S.) than that of the overall population (which is generally the basis of the inflation monitoring and retirement planning).
In a recent WSJ article “The danger in ‘senior’ inflation“ Brett Arends tackles the differences in inflation experienced by U.S. seniors as compared to the official CPI numbers. He points out that while high-tech equipment and clothing costs are falling, food, energy, flying, hospital/medical services are rising. Seniors consume relatively little of the former am more of the latter. Furthermore falling house price reduce the inflation for the young and reduce income opportunity for seniors (via sale of home or reverse mortgages). And his clincher is the impact on the readiness of tens of millions of Americans whose retirement savings calculations are based on the standard CPI will be devastated if the ‘senior’ inflation is plugged in instead. Another problem is that Social Security, Canada Pension Plan and (to the extent) defined benefit pension benefits are indexed, are all anchored to the CPI rather than the actual inflation experienced by seniors.
Professor Milevsky of York University in “Inflation rates and retirement” points out that the U.S. Department of Labor (BLS) actually has a CPI-E (Elderly) and CPI-W (Wage earners and Workers) where consumption components can be radically different. He provides a table of the relative importance of the components. For example housing and medical care for CPI-E is about 58% versus only 45% for CPI-W. His bottom line is that between 1982- 2006, CPI-E increased at a compound rate of 3.30% as compared to 2.96% for CPI-W. He then drives home the importance of the difference from CPI-W, with the fact that each one of us has sufficiently different spending profile that we should really be looking at CPI-ME based on what city we live in and what types of goods and services we spend our money on. So that you should be using your personal CPI-ME for your financial planning calculations. (He even goes a step further to suggest that you may want to invest in assets that would benefit from a shock to your personal inflation rate, a form of asset liability matching). Last summer Bill Hanley in Financial Post’s “How’s your price index” also talks about introducing the HPI ( Hanley Price Index) which would be a more representative measure of the of the inflationary headwinds he is facing in financing his retirement spending, than the official CPI which is based on a goods and services basket significantly different than his. There is also an interesting related article from the New York Fed “Social Security and the CPI-E” which extends the discussion to the impact of adoption of CPI-E as the basis of Social Security indexation and the impact on its funded status.)
The most up to date Canadian status on ‘senior’ inflation differential from the inflation experienced by the average population, that I was able to find, was reported in “The consumer price index” was covering the period of 1992-2004 (a little out of date, but I couldn’t find anything more recent). This report showed that seniors did not experience a substantially different inflation rates from the average population; while the senior basket was different from the average Canadian`s basket the increases in part of the basket were mostly offset by decreases in other parts. Specifically, seniors experienced 1.95% inflation compared to the average Canadian’s 1.86%. The combined housing and medical component was (much smaller than in the U.S. survey) at 43% and 31% for seniors and average population and the inflation of these element was about in line with the overall inflation (whereas in the U.S. these grew significantly faster than overall level). It is interesting to note that where there was a significant difference was between the renter and home-owner subgroups among seniors, with renters experiencing a 1.7% inflation compared to 2.1% for home-owners.
In Canada the CPI based on Bank of Canada figures has increased from 86.6 to 111.8 over the past 13 years, or at a compound rate of about 2% per year; no doubt this was significantly helped by the rapidly rising value of the loonie. The comparable BLS figures for the past 10 years were an increase from 158.4 to 206.7 for CPI-W for a compounded growth of 2.7%, but accelerating as last 12 months inflation was 4.7%! That is a dramatically different level of inflation from the Canadian one.
I’ve done a couple of quick runs using Jim Richmond’s Flexible Retirement Planner that I have referred to before and came up with some interesting numbers. The following calculations are based on a 60 year old starting a 40 year retirement with $1,000,000 assets using what he calls ‘Moderate Risk’ style with an average return of 8.5% and a standard deviation of 9.8%. Then keeping the Probability of Success constant (at about 82%) I calculated the impact of changing assumed inflation rate for the expected retirement.
The impact of using the CPI-E (3.3%) versus CPI-W (2.93%) means you have to reduce the real annual withdrawals by 5% to maintain the same probability of success. The impact of increasing inflation from 3% to 4%, 5%, 6% and 10% would mean that to maintain the same withdrawal rates you’d have to start with $1.13M, $1.3M, $1.54M and $3.6M respectively, instead of $1.0M at 3%. Alternately you’d have to reduce your real annual withdrawals by 12%, 23%, 36% and 72% respectively.
So in the context of the recent jump in U.S. inflation of 4.7% over the past year (should that stay as the expected inflation for the duration of the next 40 years of retirement) as compared to the 2.7% inflation of the previous 10 years, that could mean a significant delay in retirement start (to be able to accumulate a further $300,000 or so using the impact of an inflation increase from 3% to 4%) or about a 23% reduction in annual withdrawals during retirement. You can play around with numbers as well in the Monte Carlo based planner, to get a feeling for the corrosive impact of inflation, but you must remember that the outputs are only as good as the inputs. Of course you must also remember Hamming’s admonition that “The purpose of computing is for insight not numbers”.
So the bottom line is that you should watch the inflation like a hawk and perhaps even look at how different is your basket the CPI basket to try to understand what the inflation figures you should be using for retirement planning. Recently there has been a lot of talk about the impact on your retirement date or income, if there is a sudden drop in the market as you approach retirement, but there is potentially an equally significant impact if there is a sudden (and sustained) increase in inflation! We won’t even talk about a return to inflation rates of the 70s and early 80s.