This article is from our April 2021 edition of MarketWatch.
11th May, 2021
Inflation can have a significant impact on your ability to achieve your financial goals. In particular, there are two key variables to consider:
Through a financial plan, we can help you to understand your own personal rate of inflation and how to allocate assets to improve the chances of meeting your goals.
It is important to consider what the impact of inflation will be on what you plan to spend your money on. A change in inflation will change the cost of your financial goals. To illustrate this, we have calculated the cumulative cost of meeting a €100,000 net spend in today’s terms 15 years away from retirement* in the table below.
*Assume that retirement spend is for a 30-year period
For each 1% increase in inflation, the cumulative cost of meeting retirement expenses increases by c35%. It's clear that inflation can have a significant impact on the future cost of your goals. Using cashflow forecasts through a financial plan is an excellent way of understanding how changes in the cost of doing the things you want to do can impact your asset base.
A change in inflation will change the cost of your financial goals.
Your financial plan can also be used to understand how your own spending patterns will change over time. Ignoring inflation, it’s likely that your annual costs will not be the same every year. For clients with younger children, education costs and mortgage repayments may form a significant part of the annual spend. For clients in the early part of retirement, their mortgage might be repaid on the house, children may be financially independent and there may be a higher discretionary spend on things like travel and entertainment. For later retirement, the discretionary spend may start to decrease a little but there could be more spent on healthcare or nursing home costs.
As we spend more time understanding clients’ spending patterns in a financial plan, we can also work with them to help clarify their personal inflation rate. Inflation measured by indices such as the Consumer Price Index (CPI) in Ireland or the Harmonised Index of Consumer Prices (HICP) in Europe are measured by a standardised basket of goods.
Source: Harmonised Index of Consumer Prices (HICP)
They are a reasonable indicator of how prices are moving generally in the economy. However, the basket of goods that you spend your money on may look very different. Figure 1 indicates how different components of the HICP index have changed since January 2015. We can see that, although the overall index has stayed relatively flat over this period, there are items such as education, housing and discretionary spend that have increased at a much higher level. These may form a higher proportion of your own personal basket of goods each year versus the index.
The final tool to help deal with the impact of inflation in a financial plan is our wealth allocation framework. We use this to align your assets, and the risk you take with them, to your short, medium and long- term goals. There will always be a requirement to hold some liquidity for emergency requirements and short-term expenditure needs, even if this is held in lower returning assets such as cash or short-dated bonds. Goals that have a medium or long-term time horizon may be more suited to our core portfolio solutions where the aim is to generate a return that beats inflation over the long term. In the event that there are assets that are in excess of your lifetime expenditure needs, such as money earmarked for the next generation, satellite investment solutions that take more concentrated risk may be suitable.
A financial plan is a powerful tool in helping you understand the impact of inflation on your ability to achieve what is most important to you. It can help demonstrate the impact of inflation on the cost of your goals and how expenditure patterns change throughout your life. Through this work we can understand what your personal rate of inflation is and how to allocate your assets in a way that manages the impact of inflation. This helps to deliver peace of mind, whatever the future may hold.