In 20-plus years of serving as a fee-only financial planner, I’ve seen several situations where external factors and individual choices have threatened to derail clients’ financial plans. Some of these situations are preventable, and others are outside of our control. The key is to identify these threats early and determine whether adjustments are necessary to ensure the plans we create with our clients stay on track.
One of the retirement threats we all need to be talking about right now is inflation. We’ve been in a pretty tame inflation environment for several decades, and the assumptions built into financial planning software — which many financial professionals use to help develop and test people’s retirement plans — have hovered around 2.4% in many cases. This makes sense, given that the average rate of inflation in the U.S. from 1990 to 2021 is. 2.48%. But is that high enough, considering the state of our current economy?
Since the pandemic, supply chain issues and consumer demand have dramatically pushed up short-term inflation in the U.S. The Consumer Price Index, a key measure of inflation, was 4.7% in 2021, a level unseen since 1990, according to Statista. The monthly 12-month inflation rate in February of 2022 was 7.9%, and with the advent of the war in Ukraine, some experts are predicting that U.S. inflation will clock in at 9% or more for 2022.
While it may be early to adjust long-term inflation assumptions in your retirement planning, if supply chain issues and consumer spending don’t become more normalized to long-term trends, an increase in inflation to even 4% over the long run could have a significant detrimental impact on retirement savings and maintaining your lifestyle throughout retirement. This bears watching and making adjustments in your projections as needed.
The commonly used 60% stocks / 40% bonds allocation averaged an annual rate of return of 11.1% during the decade ending in 2021, according to Goldman Sachs. Based on longer time horizons, we typically do not project more than a 7% expected return for similar balanced portfolios. When making retirement plans, jumping from an assumed inflation rate of 2.4% to a rate of 4% reduces the net return on the typical portfolio from 4.6% to 3%. This seemingly small difference can have a huge impact on portfolio sufficiency projections, and in your ability to maintain your purchasing power throughout your retirement.
How should you deal with this? First of all, just be aware that inflation expectations are a very important input into financial planning calculations. Make sure you have a clear understanding of what the inflation assumption is in the financial planning tool that your advisor is using. According to the World Bank database, the average rate of inflation in the U.S. from 1961-2020 is 3.3%. If your assumption is less than this, perhaps it deserves more evaluation.