Financial planning and inflation assumptions

The inflation experience differs between clients, which means financial advisers must plan accordingly!

Compiling investment strategies or financial plans often requires financial advisers to apply a forecast inflation numbers to models, in order to provide a client with a thorough plan.

Official inflation numbers and reasonable inflation forecasts on official inflation figures are around for those financial advisers that research adequately, but the question is whether or not planning or modeling around official inflation numbers is enough for a comprehensive plan?. In short, the answer is that it is not!

Different experiences

The monthly budgets of each individual client differs significantly. Each client will have different 'big ticket items' that dominate the budget.

For example, 'big ticket items' or budget items that absorb larger cash flows within a budget i.e. bigger spend areas, may be education and medical costs for one client while food, petrol and households expenses may dominate the budget of another client. Each of these budget items carriesy its their own inflation levels or increase at different rates, which are often different and higher than official inflation numbers.

This does not make official inflation rates incorrect or totally inappropriate, it simply means that clients often experience inflation at a rate higher than the official inflation rate in their day to day lives within households. Investment plans or strategiesy for these clients could therefore incorporate a higher level of inflation into modeling as a consequence.

A possible solution

Broadly speaking, the official inflation figure plus 2% may be more appropriate.

This is a more conservative approach to modeling or financial planning, but at least when discussing returns from an investment, or real returns more particularly, a client may be more easily assured with a more more accurate inflation assumption that goes toward comprehensive investment planning and appropriate strategy.

Staying ahead of inflation

A real return is the return from on an investment portfolio that is adjusted for inflation. If a portfolio returned 14% over a particular 12-month term, for example, and official inflation measured 6% over this time, the investment would have delivered a return of 8%.

In other words, the investment strategy or plan initially agreed on by the financial adviser and client retained the purchasing power of money by delivering a real return (and remaining ahead of inflation).

Financial advisers are able to tailor modeling around actual client experiences of inflation by simply being close to the client's regular (monthly) budget and knowing certain of the 'bigger spend items' within a particular client's budget often increase at rates ahead of the official inflation rate.

Official inflation rates plus 2% may ensure that modeling is more accurate or in line with a clients actual inflation experience.

Universally speaking, real returns* from broad global asset classes over the past century have been in the region of:

Equities       +6%
Bonds         +2%
Cash           +1%

Historic real returns from the local equity market have been slightly higher than that of global equities at 8% and one would expect this, due to the above average risk associated with this asset class.

Protecting the purchasing power of assets

Financial advisers and clients should strive to compile and align investments that seek to at least provide real returns or returns ahead of inflation, and in so doing protect the purchasing power of assets.

Modeling plans around an inflation forecast of official inflation plus 2% may be a conservative, but important, step in aligning real return expectations with a client's actual inflation experience.