Digging into Inflation
By Brad Thomason, CPA
Elsewhere I’ve written about the importance of accounting for inflation when doing long-term planning. In simplest terms, any plan which doesn’t acknowledge the change in a dollar’s purchasing power over long periods of time, is flawed. But what exactly is inflation? You would think that for something this important, there would be a clear-cut answer to that question. But that may not be the case.
Below are some things to think about to get a fuller appreciation for what inflation is, and how it will likely impact your financial situation in the years to come.
Inflation is more than the change in the Consumer Price Index (CPI). CPI is a terribly complicated calculation, with lots of nooks and crannies for important data to be lost in the combining and averaging process. It attempts to gauge the change in overall prices changes, though it focuses just on Urban consumers, and it explicitly excludes changes in things like tax rates. Core rates, which ignore the effect of food and energy are often used in lieu of the more general measurement. The Bureau of Labor Statistics has a good website addressing a lot of the details about CPI. But a direct quote from the FAQ on their site is instructive for this point: Q-Does the CPI measure my experience with price changes? A-Not necessarily…
People of Different Ages Have Different Buying Patterns. CPI is made up of data from eight major groupings. Examples include Apparel, Transportation and Recreation. As you might imagine, each of these components can increase at a different rate than the others. This matters to retirees because they are the ones who account for the bulk of medical spending and the inflation rate on such expenditures is often one of the higher components. In other words, medical spending often increases at a faster rate than general CPI. That tendency has more of an impact on the purchasing power of a dollar owned by someone in their 80s than it does someone in their 20s, an important nuance which often goes unmentioned. The fact that retirees spend proportionally more of their total budget on medical care, and that the medical-specific rate is higher, sets the stage for general CPI to grossly underestimate the amount of purchasing power loss that someone might encounter in the decades after retirement.
What We Buy Changes Over Time. If you try to calculate the rate of inflation on broadband data costs from 1965 through 2015 you are in for a quite the challenge. Because in 1965 there was no such thing as broadband. Or cell phones. Or cable TV. Or MRIs and CPAP machines. Pretty tough to calculate the rate of change on something that used to not exist. The march of technology not only gives us better versions of old tools and toys, it also creates things we never even thought of in the past. Many of them become commonplace over the course of a decade or two, and in so doing create entirely new possibilities for spending money. We do not know what the future holds, but if we had to make a guess about whether that trend will continue or come to a stop, I know which way I’m betting. The planning implication is clear: it’s not enough to account for the possibility of price increases for things we buy today, we also have to account for the fact that in the future we will probably be buying a greater number of things than we are today, some of which might not even exist yet.
Accounting for inflation is important if you want your long-term projections to have any hope at all of coming close to matching your future reality. It would be nice if doing so were as easy as popping in a simple number and letting the spreadsheet do the rest. Unfortunately, it may not be that easy. Those who get past the annoyance of that fact and take the time to explore the less obvious aspects of this issue stand to benefit from having a more realistic sense of what their resource will and won’t be able to pay for in the years to come.