A key issue when analysing whether you have enough invested to retire is how much you expect costs of living to increase by through your years of retirement.
This is a tough number to determine. Many economists have trouble enough identifying what it has been historically yet alone trying to predict what it might be for the next 20 or 40 years.
Using history as a gauge
Economists tend to start their analysis using the Consumer Price Index (CPI). In Australia the Australian Bureau of Statistics (ABS) has the responsibility of determining this index level every quarter using a pre-defined basket of goods. It calculates the cost of that basket of goods and compares this with previous levels to calculate how much prices have changed.
The database I looked at placed the CPI at a rate of 5.27% since October 1948. However this period was marked by extremely high inflation through the 70s, 80s & early 90s. (Inflation was close to 10% on average from the beginning of 1973 until the end of the 80s) Since then central banks and governments around the world have implemented inflation targeting as a core economic policy and through doing so have driven inflation down. (It has averaged 2.7% from the beginning of 1990 until the end of March 2013 in Australia.)
In Australia the Reserve Bank of Australia target rate of inflation is somewhere between 2 and 3% over the course of the economic cycle. Hopefully a firm lid can be kept on inflation so that it will not climb back to the levels experienced in the 70s and 80s.
What is current level of inflation?
The most recent reading of the Consumer Price index suggests that the cost of living rose by 2.5% for the 12 months to the end of March 2013.
Some commentators suggest that the basket of goods used by the Australian Bureau of Statistic might not provide an accurate reading of cost rises for retirees. I also look at 2 other measures to see how costs are faring for retirees:
1) The ASFA Retirement Standard
2) The Australian Bureau of Statistics Selected Living Cost Indexes
ASFA Retirement Standard
Every quarter the Association of Superannuation Funds of Australia (ASFA) commission a report conducted by Westpac to gauge the cost of living in retirement for singles or couples with a modest or comfortable lifestyle.
Figures to the end of December 2012 suggest that costs have risen by:
2.99% for a single person with a modest lifestyle
1.93% for a single person with a comfortable lifestyle
2.78% for a couple with a modest lifestyle
1.97% for a couple with a comfortable lifestyle
For me this suggests that cost s for those in retirement are rising basically in line with the official CPI figures and with in the Reserve Bank target.
The Australian Bureau of Statistics Selected Living Cost Indexes
The ABS has started to release living cost indexes on a quarterly basis for a number of broad groups. The latest data release for the period ending March 2013 suggests the annual increase in costs have been:
2.7% Pensioners & Beneficiaries
2.8% Age Pensioners
2.3% Self Funded Retirees
So again these numbers fall close to the broad CPI figure and with the Reserve Bank’s 2 to 3% target.
So what level of inflation should be used for predictive purposes?
My approach is to start with the current rates of inflation. If these levels are below the 3% Reserve Bank threshold (which they currently are) I would use 3% . If they are above the 3% threshold I would tend to use the current levels. i.e. I try to use the worse rate to hopefully build in a level of conservatism.
If you are an inflation bear, you might want to use a rate more like 5% on average.
If you can use a higher level of inflation and still meet your retirement goals all the better.
But how will investments respond in different inflationary environments?
A final aspect to consider is how might investment returns behave in various inflationary environments?
Historically, over the long term, returns on asset classes tend to be within percentage bandwidths from the prevailing level of inflation. For example an oft-used rule of thumb is that shares should provide a return of 6 to 7% above inflation.
The real art is to make sure that your investment mix has enough exposure to investments that tend to perform better in inflationary periods.
Unfortunately there is not enough time to go into details now but I will come back to it in another day.