Projecting clients’ expenses in your financial planning program requires the planner to set an assumed inflation rate. A small change to the assumed inflation rate can make a big impact in the overall success of a client’s plan.
Inflationdata.com provides a rich resource for information on inflation data, including the chart below displaying average annual inflation by decade. Financial plans typically project over a long time span of 20+ years. If you look at inflation over the last 30 years as a base to help estimate a reasonable inflation rate for the next 30 years, you would find an average (using the geometic mean) inflation rate of about 2.6%. However, if you step back 50 years, to include higher inflation periods of the 70’s and 80’s, the average rate would be about 3.7%. Projecting expenses using a 2.6% compared to a 3.7% inflation rate will lead to very different results, especially over a 20+ year plan.
To illustrate the impact, let’s use the “What If?” in Silver Financial Planner. Below are the results of a retirement projection created with Silver Financial Planner for a married couple in their 50s, projecting out 40 years until age 90.
The graph on the left displays their retirement assets based on the information entered for the plan, with a 2.6% inflation rate on expenses. The graph on the right changes only the inflation rate, from 2.6% to 3.7%. The clients’ retirement outlook appears rosy with the 2.6% inflation rate, with a 98% Monte Carlo success rate. The retirement outlook changes completely using the 3.7% inflation rate, projecting the clients assets will be depleted 5 years prior to life expectancy, with a 15% Monte Carlo success rate.
The graph from Inflationdata.com provides the long-term average inflation rate from 1913-2013 as 3.22%. The rate to use for your clients’ projections is up to you as a planner. We suggest being conservative in both inflation and rates of returns, and/or illustrating the impact of changing assumptions like the inflation rate using the “What If?” in Silver, or scenario comparisons in TOTAL Planning Suite.