Inflation is one of the most important components of a long-term financial plan. Financial advisors include a prediction of inflation in all of their models about how investments will perform in the future, and how much money their clients will have available for spending.
Inflation is relentless. It goes up each year, and it builds on the inflation that has already occured.
A car that cost $20,000 this year and then has two years of inflation at 5% each year will increase by $1,000 in the first year and $1,050 in the second year. And then it will continue to grow at a higher number each year.
Economists say that inflation “robs money of its purchasing power.” In other words, it costs more to buy the same thing in the future than it costs today. And this phenomenon must be accounted for in any financial plan.
Typically, a financial advisor will use a software program to help devise a financial plan for a client. This plan will have the client’s current spending, as well as estimates for the spending for many years into the future. Those future spending estimates will include an adjustment for inflation because the advisor knows that most things (milk, cars, healthcare, cable TV, etc.) will rise each year. The advisor compares those anticipated spending levels to the client’s anticipated income levels in future years, and he sees whether there is an imbalance. Quite often, the surprise to the client is that inflation has doubled his level of spending, even though he is not buying any more than he did in the past!
One of the ways that a person can overcome the effects of inflation is to include investments that are expected to increase by more than the rate of inflation each year. If inflation is 2% and an investment earns 5%, then that’s a “real” gain of 3%. But to get those higher rewards, an investor must take greater risk.
However, a person who tries to avoid “investment risk” by making only ultra-safe investments will actually increase his or her “inflation risk.” Inflation risk is the risk that inflation will erode the value of a person’s money over time. And this is why financial advisors say that ultra-safe investments like money market accounts actually do carry risk. A money market doesn’t have much risk of actually going down in value (though it has happened to a few of them in 2008), but it does have the risk that it won’t rise in value enough to cover inflation. Thus, the amount that an investment can purchase in 10 years might decline, even though the investment actually increased a little.
For the investor who isn’t working with a financial planner, the good news is that all the off-the-shelf software for financial planning includes an inflation factor. That factor can be adjusted if a person wants to play it “safer” by assuming that inflation will be higher in the future than it has been in the past. That same inflation adjustment can be used to increase the value of a person’s Social Security payments each year, as well as any other payments that are “indexed” to inflation, such as a pension or a health insurance contribution from a former employer.
The bottom line is that inflation is a crucial factor to anyone who is making financial plans for more than 5 years in the future. Failure to account for inflation will guarantee that the plan will be out of balance, just when it’s needed the most.