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Rethinking inflation during retirement

The consumer price index may not be the best yardstick for most retirees

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By David Glickman

March 1, 2009 6:01 am ET

Financial advisers must consider many types of risk when creating and executing successful retirement income plans, but perhaps none is more insidious than inflation.

While a whiff of deflation is in the air, it still seems that certain goods and services keep rising in price, straining fixed-income streams such as pensions and annuities, as well as debasing the income-generating value of retirement savings plans.

Recognizing this, most advisers have done a good job of talking to investors about the need to continue to invest a portion of their assets for growth, even during retirement. In addition, virtually all retirement income tools account for inflation in estimating income needs over the planning horizon.

Unfortunately, the chief yardstick that advisers and software tool providers typically have relied on to measure inflation — the consumer price index — is probably not the best choice. In fact, while the CPI has become the authoritative source of inflation estimates for planning purposes, it may be dangerous to the retirement health of your clients.

The CPI is the best-known measure of inflation for the U.S. economy. It is widely used by business executives, all levels of government, labor unions, investors and others as a basis for economic decision making and as a means for adjusting prices, costs, taxation rates and income streams over time.

Typically tied to the CPI are collective-bargaining agreements, Social Security and federal-employee pension benefits, food stamp benefits, federal-income-tax adjustments, the principal value of Treasury inflation protected securities and often rent, alimony and child support payments.

Yet when it comes to planning for the income needs of retirees, the CPI may very well be an imprecise measure because it is designed to measure the impact of inflation on the typical U.S. consumer, and retirees are rarely typical.

For example, retirees often incur greater health care expenses than the general population, and over the years, inflation in medical care has outpaced other types of expenses. Retirees also may spend more on food or recreation and less on housing, transportation or education than other segments of the population.

To illustrate this effect, we modeled the actual inflation experienced by a retiree with much-higher-than-average health care and food expenses. We offset that by using lower cost estimates for housing, transportation, recreation and education.

Using unadjusted CPI figures for the 12-month period ended in November, the typical consumer experienced an inflation rate of 1.1%. By comparison, our hypothetical retiree saw his expenses rise by 1.7% — a difference of 55%.

Although the absolute difference in inflation rates of just 0.6 percentage points may seem small, consider its compounded effect over a retirement of 20 to 25 years. Further, in periods with higher average inflation, these differences likely will be even more pronounced.

Your clients may not look exactly like our hypothetical retiree. Yet most advisers still use historical-average inflation rates when creating retirement income plans for their clients, largely because most retirement-income-planning tools embed historical CPI-based inflation rates in their calculations.

For clients whose expense profiles suggest that they will experience higher-than-average inflation during retirement, the plans built through these methodologies and tools may underestimate income needs. As a result, following these plans could put clients at greater risk of failure and expose advisers to client backlash in terms of account losses or even arbitration and litigation.

To develop more-accurate inflation forecasts, advisers should develop individualized inflation estimates for their pre-retiree and retired clients as part of a budgeting process.

This can be done most effectively by assigning a separate inflation rate to each budget item.

Advisers also should compare individualized estimates with the average CPI. During the planning process, this can mean raising the inflation assumptions for those who are likely to experience higher-than-average rates.

Finally, talk to your planning-tool provider. If vendors don't allow you to modify inflation assumptions for clients, tell them why they should.

Making accurate assumptions about inflation isn't easy. But not trying to assess inflation accurately is dangerous.

David Glickman, formerly a vice president of strategic marketing at Fidelity Investments of Boston, is a consultant in that city in the areas of retirement income and adviser practice management. He can be reached at daveglickman@gmail.com.

For archived columns, go to investmentnews.com/retirementwatch.

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