If you're planning to buy your first home in a year or a new television a few months from now, you probably don't need to worry too much about inflation. If you had budgeted £210,000 for your house but the final purchase price was £213,000, or if you wind up paying £400 for the television that was £350 last Christmas, the overage might be unwelcome, but it probably won't throw too big a wrench into your plans. (And given how home prices have been trending down during the past several years--and electronics have been getting better and cheaper for an even longer time frame--it's very likely that you'll not encounter any inflation at all in the near term.)
But when it comes to your retirement, you're not making a one-time purchase. Although it might be several years before you actually retire, not factoring in rising prices when planning for this goal can spell the difference between comfortably realising your financial targets and scrambling to make up for a shortfall when it's too late to make a difference.
On a stand-alone basis, inflation might look like a small foe. Why worry about 2%, 3%, or even 5% per year?
The reason is straightforward: Compounded over many years, inflation can actually be an enormous swing factor.
Say a 50-year-old has done a back-of-the-envelope calculation of how much he needs to sock away for his retirement. He'd like his money to last from the time he retires at 67 until he's 95. He's using the standard rule of thumb that he'll need 80% of his current income of £100,000 during retirement (let's stick to large, round numbers for ease of calculation). Assuming a 5% rate of return on his investments and no help from a State Pension, he might conclude he needs to retire with about £1.3 million in the bank.
That amount sounds manageable (or not, depending on your perspective). But unfortunately, the estimate is way off, because that simple calculation doesn't factor in the role of inflation. If we assume annual cost-of-living increases of 3.5% then the amount he needs to retire jumps up to £3.3 million. That's because goods that cost him £80,000 today will ring in at nearly £140,000 when he retires in 17 years, and that amount will escalate steadily throughout his retirement, topping £300,000 per year by the time he's 95. Were he to exit the workforce at 67 and begin tapping his portfolio with just £1.3 million in the bank, he'd likely be out of money by age 76--a catastrophic shortfall if he lives another 20 years.
That's a huge discrepancy. But because saving for retirement is daunting to begin with--and because annual inflation statistics appear to be pretty benign when viewed on a one-off basis--many pre-retirees and other long-term investors fail to consider the potential for higher prices when determining how much they need to set aside. In so doing, they might derive a false sense of security about the size of their nest eggs, and they might also fail to add inflation hedges that can help maintain the purchasing power of income they draw from their portfolios.
To make sure you don't fall into this trap, consider the following when planning for retirement or any other long-term goal.
Be Holistic (and Realistic)
If you're saving for a goal that's either far off into the future or that you'll be funding over a multiyear period, it's a good first step to calculate how much you'll need and then back into an appropriate savings rate. As you do so, make sure any calculation or tool you're using is holistic; very basic calculations, as I mentioned above, aren't going to cut it. Not only should you be factoring in inflation, but you should also assume a realistic rate of return on your investments. (For portfolios that balance both stocks and bonds, a combined return rate of 4% or 5% is reasonable.) Finally, good retirement calculators should be able to factor in State and personal/company pensions and should also take into account that you'll pay taxes when you withdraw make pension withdrawals.
Customise It
Many retirement-planning calculators use an inflation rate of 2% or 3% as the default. That's in line with historic norms, but it's also important to recognise that your own inflation rate could vary significantly from the averages. If you own your own home outright or have a fixed-rate mortgage, you won't have to cope with increasing housing costs or other forms of upkeep. But inflation might still be higher for you in retirement than it is now because you could face higher medical costs over the years. For more on how inflation is a highly individualised phenomenon, check out Jason Zweig's excellent column on this topic.
See If You've Got Any Protection
As daunting as it may be to look at your savings target in real (that is, inflation-adjusted terms), remember that you might be able to lean on inflation-adjusted sources of income during retirement. State pension payments are adjusted to keep up with inflation (from 2012, basic state pension increases will switch to track the Consumer Price Index rather than the Retail Price Index, which may mean lower increases). Income from some pensions and annuities might also be inflation-adjusted. The more of your income needs that such sources provide, the less you need to worry about inflation.
Recognise That "Safe" May Be Sorry
Ever since the financial crisis and market meltdown from 2007 through early 2009, many investors have retreated to cash and bonds, in the view that a small but certain return is preferable to the wild gyrations of stocks. But with cash and bond yields as low as they are, as well as the ever-present possibility of inflation, it's important to remember that the safety of bonds and cash may be illusory, as inflation could gobble up every bit of their meagre yields and then some. Only safe investments that have an inflation adjustment, such as inflation-linked bonds, provide direct protection against inflation and even they can become overpriced from time to time.
Christine Benz is director of personal finance with Morningstar. This article has been updated for the U.K. by Morningstar.co.uk editor Holly Cook.
