Why it's crucial for investors to incorporate inflation into their financial planning

 
Fisher Investments UK Contributor
Understanding inflation’s impact is only half the battle, though. When selecting investments, we believe it is important to consider inflation and remember historically lower-returning asset classes like cash and fixed interest haven’t always provided sufficient returns to offset it, never mind supply the growth you might need to sustain higher cash flows late in life.

We often find media coverage fretting inflation’s impact on consumer spending—particularly true after UK inflation jumped over the last couple years. In our view, though, British investors should be more focused on whether their financial plans take it into account. We believe doing so is vital to increasing the likelihood of reaching your goals.

The Office for National Statistics (ONS) tracks inflation and releases a few different measurements each month. Among these, the headline Consumer Price Index (CPI) gets the most media attention. Since 1989, when ONS data begin, year-over-year CPI inflation has averaged 2.6 per cent. This reduces the pound’s purchasing power bit by bit.

Exhibit 1: Historical UK Inflation


Source: Office for National Statistics, as of 1/5/2018. Year-over-year percentage change in the UK Consumer Price Index, January 1989 – March 2018.

We aren’t saying this data is predictive—future inflation could be higher or lower. But in our view, they may be a useful guide to inflation’s potential impact—which may be bigger than you think. Take a simple hypothetical scenario in which you plan to withdraw £50k per annum from your savings in retirement. As Exhibit 2 shows, over a 30-year span—presuming inflation’s historical average held—that sum would lose almost 60 per cent of its purchasing power.

Exhibit 2: Inflation Cuts Into Real Withdrawal Values


Source: Office for National Statistics and Fisher Investments Research, as of 20/4/2018.

Want to retain the same purchasing power in 30 years as today? You might need to withdraw about £110,000 then based on historical inflation rates—or potentially even more.[i] Whilst it is easy to think of inflation as the average media coverage frequently focuses on, many people’s living expenses don’t increase at that rate. The reason: The CPI basket—a collection of goods and services the ONS uses to calculate inflation—isn’t intended to reflect a true cost-of-living index. In 2018, for example, unless you buy ceramic tiles, pyjamas, a patio furniture set, a new car, a used car and a motorcycle, hire a nanny, go to the hospital and purchase the nearly 700 other items and services in the basket, your personal inflation rate will probably differ to some degree from the average.

This is why we believe it is important to take stock of your likely spending patterns, both now and in the future. For example, some might choose to help with grandkids’ education costs—a generous but potentially expensive move. Since January 1995, prices in this category have risen a whopping 177 per cent.[ii]

Health care costs are another big consideration for many. Although the government (mainly through the NHS) accounted for the majority of UK health care spending in 2016, out of pocket expenditures and voluntary health insurance—which together capture the bulk of private health care spending—totalled £35.2 billion.[iii] Moreover, long-term care—which the NHS typically doesn’t cover—accounted for 30 per cent of private health care spending.[iv] Data suggests this is a fast-growing category. Out-of-pocket expenditure on long-term care rose 6.8 per cent y/y in 2016.[v] Looking back further, a Telegraph analysis of data gathered by LaingBuisson, a health care consultancy, showed residential care costs nearly doubled from 1998 – 2017—with private payers facing the steepest increases.[vi] On the whole, health care costs have risen 42 per cent since January 2005.[vii] If private and public expenditures are rising roughly in tandem, then planning for higher personal health care spending seems sensible to us.

Again, it probably isn’t possible to know for sure what you will spend money on or how fast those prices will rise years from now. But we don’t believe that should stop you from making educated guesses. Getting a sense of probabilities can help set expectations—crucial for planning, in our view. Moreover, we think the dangers of underestimating inflation’s impact on your finances are greater than those of overestimating. Discovering down the road you have a bigger-than-anticipated cushion is far more pleasant than the reverse.

Understanding inflation’s impact is only half the battle, though. When selecting investments, we believe it is important to consider inflation and remember historically lower-returning asset classes like cash and fixed interest haven’t always provided sufficient returns to offset it, never mind supply the growth you might need to sustain higher cash flows late in life. In our view, concentrating solely in these assets may leave you short of the returns many investors need to supplement your pension. To be sure, they can make sense if you have big near-term spending needs and want to reduce volatility—but this may come at the expense of the long-term growth necessary to fund future cash flow needs. Withdrawing too much too early can also compound issues later in life, leaving you with less savings at a critical juncture. In our view, a helpful guideline is to limit annual withdrawals to roughly 4 per cent of the starting value annually, adjusting the amount for inflation over time.

For those who don’t incorporate inflation into their financial planning, the loss of purchasing power might be unexpected—or potentially force major life changes to make ends meet in old age. Whilst we don’t think there is a one-size-fits-all response to inflation, we believe an awareness of its wealth-sapping effects may help you better evaluate your investment options and select those that don’t leave you short of the returns you need to achieve your long-term cash flow goals.

Investing in equity markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance neither guarantees nor reliably indicates future performance. The value of investments and the income from them will fluctuate with world equity markets and international currency exchange rates.

This document constitutes the general views of Fisher Investments and should not be regarded as personalised investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts may be, as accurate as any contained herein.

[i] Source: Office for National Statistics and Fisher Investments Research, as of 25/4/2018.

[ii] Ibid.

[iii] Source: Office for National Statistics, as of 25/4/2018.

[iv] Ibid.

[v] Ibid.

[vi] “Why care costs are spiralling at up to twice inflation,” Sam Meadows, The Telegraph, 29/10/2017. https://www.telegraph.co.uk/money/consumer-affairs/care-costs-spiralling-twice-inflation/

[vii] Source: Office for National Statistics, as of 13/4/2018.