Inflation and financial planning in these turbulent times | money matters

As financial planners, much of the work we do involves looking into the future and making assumptions about things like the returns on various types and categories of investments, the implications of tax code changes and the impact of inflation on future customer spending.

The quality of the assumptions made for these factors can have a huge impact on the quality and usefulness of a financial plan.

Inflation for most of the past two decades has been low, below 2%, so the recent dramatic increase in inflation has come as a surprise to many.

There are several reasons for the recent rise in inflation. The recovery of the global (goods) supply chain following the covid shutdowns has been slower than expected. The war in Ukraine has led to supply cuts in global oil and food supply chains.

Another factor has been the strong growth of the US money supply over the past two years, driven by both the government’s extensive stimulus programs and the Federal Reserve’s monetary easing, both of which were done to support recovery from COVID.

Inflation assumptions are an important part of developing a financial plan, as inflation impacts clients’ costs for living expenses, income streams such as social security, as well as expected investment returns. In incorporating inflation assumptions into a financial plan, some planners use inflation data while others may use forecasts for future inflation rates. We think trying to forecast inflation is quite difficult, so we use the 50-year annual inflation rate. We believe this number is real, measurable and based on real data (it’s currently 3.9% by the way).

But what about a time like today when inflation has risen dramatically? It might be tempting to assume that inflation will stay at 8%, but a reasonable analysis would most likely lead to the conclusion that this will not be the case. It would therefore be unwise to use 8% as a long-term inflation rate in a financial plan, as this could significantly overestimate a client’s future expenses, and possibly income as well. Moreover, how to predict inflation for the next 30, 40 or 50 years? It would be practically impossible.

Ultimately, the future inflation rate assumption is based on both historical data and the reasoned decision that, because we really can’t predict inflation, a reality-based number ( i.e. actual historical data), is probably a more optimal choice and would also involve the least risk. The “risk” would be to use a figure that is so far from a reasonable assumption that it would significantly degrade the value of the plan. The same goes for return on investment assumptions: using irresponsible return projections can do a lot of damage to the financial plan. As planners, a big part of our job is to analyze historical and current data to make well thought out projections. , reasonable and reduce the risks of the plan as much as possible.

Robert Toomey, CFA/CFP, is vice president of research for SR Schill & Associates on Mercer Island.