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Consumer Price Index and Consumption

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Economists discuss the choices people make with their earned income as a choice between consumption (spending) and savings. They remind us that we apply our human capital (our skills and time) to earn financial capital (our income or wages) and that we then need to divide that money up into spending and savings. The Richest Man in Babylon urged wage earners to acknowledge that "a part of all they earn is theirs to keep" and, even 4,000 years ago, suggested that we save 10% of what we earn. The reason to do this is that there will come a time when your human capital will diminish and you will only be left with your savings, or financial capital, from which you need to limit your withdrawals to about 5% per year to allow your savings to last over your entire life time. Five percent per year is IFA's very rough estimate for our clients. The actual number will vary with retirees unique situations. 

The Consumer Price Index is usually a positive percentage and for estimates of portfolio survival in your retirement, it only applies to what you consume (your spending). It is not the "Savers Price Index" and, for the estimate of portfolio survival, it does not apply to what you have saved. Your savings should only be thought to increase with the full excepted rate of return of your index portfolio, preferably on a glide path. That expected rate of return on your investments should not be decreased by the CPI. Many financial journalists, financial advisors, economists and investors confuse the use of the CPI by making it a negative number and applying it to the growth of their savings.

You may have recently used one of IFA's popular financial tools like the Retirement Analyzer to get an idea of how well prepared you are for one of life’s financial milestones. If so, you may have noticed that the projected ending dollar amount of your portfolio is NOT adjusted downward to reflect the so-called purchasing power of the entire portfolio. The inflation adjusted value is called a real value, where the unadjusted ending value is called a nominal value. If the values were in the equivalent of today’s dollars, or real value, they would be a lot lower and would NOT properly reflect the actual dollar amount projected to be in your accounts, because they would be reduced for projected inflation of 3 to 4%. 

The only inflation adjustment you need to make is to increase the withdrawal amount. Those withdrawals will need to increase with inflation so that you can maintain a certain standard of living. Normally, it is assumed that the cost of living increases at the rate of the Consumer Price Index (CPI), but there can definitely be exceptions such as someone who is facing high health care related expenses which can inflate faster than CPI. Hopefully, you only consume your withdrawals from your savings and not your entire savings all at once.

Here is the key point: The future value of your account must be able to support your future value of the goods and services you need to purchase. If your withdrawals are expressed in nominal dollars, your account value at that time should also be expressed in nominal dollars. Only then will you be able to estimate if you are in a good position to purchase what you need in your retirement. 

If you would like to learn more about how to get the most out of the investment planning tools in IFA.com, such as the Retirement Analyzer, please give us a call at 888-643-3133.