Retirement modelling - inflation

[eyebeebe]

I keep going back and forth in my head on this, so any input appreciated.

For my accumulation phase in my GIA and my pensions I assume a conservative 3% post inflation return from a mix of equity and PE funds. I will be able to take all of the capital from my pension funds and self manage upon early retirement. During retirement, I assume that any state pensions will be index linked and that I will continue to invest in equities with the same post inflation return.

Currently I am assuming that expenditure is based on 2021 numbers on the basis that inflation is dealt with by the return on investments on a pot that is obviously larger than annual expenditure.

I have a nagging doubt that I should be inflating the expenditure too, but like I say keep flip-flopping.

Slightly added complication is that I have lived in a basically zero inflation environment (Switzerland) for the last 12 years and inflation expectations remain close to zero for the next 10 years before I plan to retire, so it's not really a phenomenon I've really experienced.

If you think it should be included in the expenditure calculation, it would be great if you could explain why. Thanks!

[bitchstewie]

I'm don't work in finance but isn't this as simple as the stuff you'll be buying will increase with inflation so presumably you need to include it?

I'd have thought the question is more what rate to use?

[Carbon Sasquatch]

In simple terms, expenditure should increase with inflation. However, your inflation number might not match anything officially quoted. That’s because you are only interested in the cost increases of what you are buying, which won’t match any of the baskets of stuff in the official numbers.

All you can really do is have a spending target. Same with the pot you build - you will have a target withdrawal rate. You then need to adjust for reality when you’re actually there - so that if your pot suddenly drops because of a market correction, you know how you’re going to respond.

You will hopefully accumulate more through better performance some years and then draw on that in the lean years. Ultimately you may need to trim your spending some years and be more relaxed in others.

[eyebeebe]

bhstewie said:

I'm don't work in finance but isn't this as simple as the stuff you'll be buying will increase with inflation so presumably you need to include it?

I'd have thought the question is more what rate to use?

Hmmm I do work in finance

Logically I agree with you, but if you plug in some simple numbers, I'm not so sure.

Let's say that my ongoing expenses are 40,000 shekels a year based on today's prices and annual inflation is 2%. Keeping the calculation simple that would mean that in 10 years that 40,000 would now be c. 49,000. But let's say that I invest 100,000 shekels per annum and it only makes a return of % i.e. inflation. That would become worth 1.1m shekels after 10 years and have a present value of c. 907,000. The expenditure to capital ratio is the same at 4.4% both now (40,000/907,000) and in 10 years (49,000/1,100,000).

This is what has me scratching my head. I think what is important is that the base period for the capital and the expenses is the same, so that you are comparing like with like. As my modelling is a post inflation return rate, I think I can use today's prices.

[eyebeebe]

Carbon Sasquatch said:

In simple terms, expenditure should increase with inflation. However, your inflation number might not match anything officially quoted. That’s because you are only interested in the cost increases of what you are buying, which won’t match any of the baskets of stuff in the official numbers.

All you can really do is have a spending target. Same with the pot you build - you will have a target withdrawal rate. You then need to adjust for reality when you’re actually there - so that if your pot suddenly drops because of a market correction, you know how you’re going to respond.

You will hopefully accumulate more through better performance some years and then draw on that in the lean years. Ultimately you may need to trim your spending some years and be more relaxed in others.

All makes sense. I think what's worrying me is that it all looks a bit too good to be true and we are going to have to take up even more expensive hobbies to burn through the pot before the dogs' home gets it! So I'm looking for flaws in my model.

[bitchstewie]

eyebeebe said:

Hmmm I do work in finance

Logically I agree with you, but if you plug in some simple numbers, I'm not so sure.

Let's say that my ongoing expenses are 40,000 shekels a year based on today's prices and annual inflation is 2%. Keeping the calculation simple that would mean that in 10 years that 40,000 would now be c. 49,000. But let's say that I invest 100,000 shekels per annum and it only makes a return of % i.e. inflation. That would become worth 1.1m shekels after 10 years and have a present value of c. 907,000. The expenditure to capital ratio is the same at 4.4% both now (40,000/907,000) and in 10 years (49,000/1,100,000).

This is what has me scratching my head. I think what is important is that the base period for the capital and the expenses is the same, so that you are comparing like with like. As my modelling is a post inflation return rate, I think I can use today's prices.

Surely you're spending more though?

So (and if you work in finance I'm about to get my arse handed to me as maths isn't my strongpoint ) to my way of thinking:

£100K in the bank now and a Ford Focus costs £10K (if only).

Fast forward 10 years and if it only grows at inflation (2% say) the £100K might be worth £122K but the car also costs £12K so surely you have to factor that in as if you ignored it you have £122K but are still assuming the car is £10K?

[aparna]

It's been a while since I read FIRE blogs, but IIRC correctly the fashionable thing to do was to ignore inflation, except for reducing any excepted annual returns by 3% or so.

No idea if this is best or not. Perhaps significant that fixed assets such as property were generally ignored in those calcs.

[eyebeebe]

bhstewie said:

Surely you're spending more though?

So (and if you work in finance I'm about to get my arse handed to me as maths isn't my strongpoint ) to my way of thinking:

£100K in the bank now and a Ford Focus costs £10K (if only).

Fast forward 10 years and if it only grows at inflation (2% say) the £100K might be worth £122K but the car also costs £12K so surely you have to factor that in as if you ignored it you have £122K but are still assuming the car is £10K?

I like to think that we don't do arse handing on these part of the site. It's not NP&E And finance is a broad church

I think that you have just agreed with my example, but have expressed it in a clearer way than I did. The Focus costs 10% of your capital now and 10% of your capital in the future. The actual amounts don't matter, it's the ratio that counts. Or at least this is what I am asking to be challenged on. Any returns above inflation, so in my case 3% are used to lower the rate of capital depletion.

aparna said:

It's been a while since I read FIRE blogs, but IIRC correctly the fashionable thing to do was to ignore inflation, except for reducing any excepted annual returns by 3% or so.

No idea if this is best or not. Perhaps significant that fixed assets such as property were generally ignored in those calcs.

Interesting that I've independently come to that conclusion, although 3% sounds a bit sporty for inflation. That could just be my frame of reference though. I also don't have any growth expectations for property. Apart from a former home in the UK that we've been too lazy to sell and is generating a decent yield, property isn't an investment class we are particularly interested in and its value is only of interest on the day of purchase (as it will either deplete assets or have an impact on a Lombard loan) and on sale if we needed to fund care and the cupboards were bare (which currently seems unlikely)

[bitchstewie]

eyebeebe said:

I like to think that we don't do arse handing on these part of the site. It's not NP&E And finance is a broad church

I think that you have just agreed with my example, but have expressed it in a clearer way than I did. The Focus costs 10% of your capital now and 10% of your capital in the future. The actual amounts don't matter, it's the ratio that counts. Or at least this is what I am asking to be challenged on. Any returns above inflation, so in my case 3% are used to lower the rate of capital depletion.

Makes sense but as Carbon Sasquatch pointed out I guess hopefully your investments/pension might rise with inflation but your personal spending might not?

There are some personal inflation calculators out there but no idea how accurate they are.

[Carbon Sasquatch]

You can model and predict as much as you like - but the reality WILL be different.

Plug your numbers into firecalc if you want to see a good example of possible outcomes and that’s just on the investing side…..

I’ve done all mine just based on today’s numbers - with a hope that my returns are slightly above inflation, so should be slightly better than I’m assuming.

EverytHing I’ve read though, seems to indicate that the key is adjusting your spending - or at least being prepared to - should things start to track differently to your expectations.

[Mr Pointy]

Does it matter where you include inflation as long as you do include it, but not twice. Personally I'd tend to include inflation with my expenditure as that is what it's going to affect. Inflation isn't going to affect the size of my investment pot, the returns I get & the charges I pay will be what does that.

I'd be leaning towards factoring inflation into my desired/expected expenditure & deciding on an expected rate of return on my investments after charges. I don't work in finance though.

[Carbon Sasquatch]

bhstewie said:

Surely you're spending more though?

So (and if you work in finance I'm about to get my arse handed to me as maths isn't my strongpoint ) to my way of thinking:

£100K in the bank now and a Ford Focus costs £10K (if only).

Fast forward 10 years and if it only grows at inflation (2% say) the £100K might be worth £122K but the car also costs £12K so surely you have to factor that in as if you ignored it you have £122K but are still assuming the car is £10K?

I’m using basic maths like that - my 100 has gone to 122 - my expense has gone from 10 to 12 - but I could now afford 12.2, so I have 0.2 as a kind of contingency.

However in real life, some things that were 10 will be 14 and others might be less than 10…..

[eyebeebe]

Mr Pointy said:

Does it matter where you include inflation as long as you do include it, but not twice. Personally I'd tend to include inflation with my expenditure as that is what it's going to affect. Inflation isn't going to affect the size of my investment pot, the returns I get & the charges I pay will be what does that.

I'd be leaning towards factoring inflation into my desired/expected expenditure & deciding on an expected rate of return on my investments after charges. I don't work in finance though.

I think I prefer it on the capital side because a) it simplifies things b) taking a conservative approach to investment return should factor it in c) as Carbon S says our personal baskets don't reflect the official statistics.

Carbon Sasquatch said:

You can model and predict as much as you like - but the reality WILL be different.

Plug your numbers into firecalc if you want to see a good example of possible outcomes and that’s just on the investing side…..

I’ve done all mine just based on today’s numbers - with a hope that my returns are slightly above inflation, so should be slightly better than I’m assuming.

EverytHing I’ve read though, seems to indicate that the key is adjusting your spending - or at least being prepared to - should things start to track differently to your expectations.

The way I've built my model is that from the capital taxes and financing charges are deducted first, followed by a reasonable budget for health insurance, utilities and household expenditure, car running costs. Those I see as relatively static from a demand perspective, but will be most impacted by inflation. Only then have I tried to work out what would be left over for discretionary spend, which can ultimately be flexed to zero, but that would clearly be a nightmare scenario. I have put the discretionary budget at 100% of everything else and run the model until I'm 90 years old. We don't run out of money. I've also put the numbers into FireCalc and the worst case scenario is that we have the same capital as we start with and the best scenario is ending up with 117m (that is not a typo!) with an average of 33m. Granted that is 100% US equities focussed.

Edited by eyebeebe on Tuesday 14th September 16:11

[bitchstewie]

Carbon Sasquatch said:

I’m using basic maths like that - my 100 has gone to 122 - my expense has gone from 10 to 12 - but I could now afford 12.2, so I have 0.2 as a kind of contingency.

However in real life, some things that were 10 will be 14 and others might be less than 10…..

Yes that's what I'd read.

As you pointed out the official inflation rate might be 2% (or whatever) and that might be what's used for your pension calculations but if 90% of the stuff you consume/buy inflates at 5% your own inflation rate on what you spend isn't 2% type thing.

[Mr Whippy]

Most pension modellers, from distant memory, will do the actual numbers you see in today’s money.

All that matters is the ROI over inflation, and then you can just do it all in today’s money if you’re looking at things simply.


The problem is actual growth will be ROI over inflation, PLUS inflation, and that has a big impact on things like tax thresholds and so on.



I was under the impression stochastic pension modellers were a thing.
I recall working with one over a decade ago and it’d give percentage likelihood’s for different outcomes.

Ie, by retirement you’d get £16,000 a year 90% chance.
Then an 80% chance of £17,000 or £15,000x
Etc.
Then at 1% was £5,000 or £50,000 kinda thing.

This was all fed out from some big accountancy statistical database thing.

[Scootersp]

Might be worth a google on stagflation, I think it's good to examine the what if's or more extreme stuff/scenarios.

Interest rates lower than inflation and central banks/governments not fighting that so that makes old style pension returns harder (more risky) doesn't it? Your/our worse case is inflation increasing and the investment income not keeping up (ie counter to our lifetimes experience, so probably won't happen!?)


https://www.investopedia.com/articles/personal-fin...

As you're in Switzerland, they are quite keen on Gold, I doubt you or your pension company are?
https://www.swissbullion.eu/en/posts/the-swiss-nat...

It's all a bit extreme and doom and gloom so hope you make it through fine with no such 'blips' and your expectation s are met :-)

[eyebeebe]

Scootersp said:

Might be worth a google on stagflation, I think it's good to examine the what if's or more extreme stuff/scenarios.

Interest rates lower than inflation and central banks/governments not fighting that so that makes old style pension returns harder (more risky) doesn't it? Your/our worse case is inflation increasing and the investment income not keeping up (ie counter to our lifetimes experience, so probably won't happen!?)


https://www.investopedia.com/articles/personal-fin...

As you're in Switzerland, they are quite keen on Gold, I doubt you or your pension company are?
https://www.swissbullion.eu/en/posts/the-swiss-nat...

It's all a bit extreme and doom and gloom so hope you make it through fine with no such 'blips' and your expectation s are met :-)

Thanks. Some interesting food for thought.

I do actually hold some physical gold about 8% of my current non-pension assets/3% total financial assets. It’s surprisingly dense and also disappointing how little you get of it for the cost. Very sparkly though.

[Scootersp]

Well it would seem then that you have most options covered and should worry less and now change to more of a "Que Sera, Sera" outlook? (I can tell from what you've said that you'll never put it totally to one side and I wouldn't recommend that either)

You are (validly) looking at the last 10% of the (unsolvable) equation when many many people won't look at the first 10%!

I cope by having low expectations of what my retirement will look like!

[JohnP68]

Mathematically it doesn’t matter which approach you take (ie real or nominal cash flows and returns) provided that you use the same approach for everything.

However, in my view the better approach is to include explicit assumptions for “inflation” and project the nominal cash flows etc. As others have said, this allows you to include different measures of inflation pre and post retirement.

[Royal Jelly]

Isn’t this all a little theoretical? There’s a million ways to model and predict the future, but ultimately it’s all white noise until you want to retire. At that point, it’s very easy to figure out what income you want in current cash terms. Then you just want it to keep up with inflation from then-on.

Surely, and this is burying your head in the sand a bit I admit; but why not just save and invest what you can, perhaps de-risk a bit as you get older, and from a certain age, check every year or so if you can retire based on whatever SWR you deem appropriate with an assumed inflation rate from that point..