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Our January asset allocation issue has received lots of positive feedback. We’re pleased so many of you have found it helpful.
But one subscriber was concerned we hadn’t spoken enough on inflation.
He’s right to be wary. Inflation can have a huge effect on long-term savings.
Mark’s original “Magic Number” essay (which we referenced heavily in the asset allocation issue) did add a step for inflation that our issue left out. We suggested handling it a bit differently. But to clear up any confusion, we wanted to address both ways.
I’ll start by briefly recapping how Mark originally addressed inflation. (I include his text at the end of this essay.)
To get your “Magic Number”—the amount of money you need to retire—you make several calculations. These calculations require an interest rate.
Mark suggests that if you want to factor inflation into your calculations, you would simply use a smaller interest rate. In essence, you are subtracting an assumed inflation rate from your interest rate. When you do this, it results in a larger Magic Number.
Mark is absolutely right. This method works.
But choosing the right inflation rate is complicated. And if the rate you choose is way off, it can badly skew your Magic Number calculations. This is why we went a slightly different way in our issue.
Let’s assume you want to use an inflation rate in your calculations…
Should you use the current, government-stated inflation rate? (Around 0.8%.) A long-term average rate? (About 3.3%.) What about a 2015 projection? (I just saw 0.6%.)
These differences would produce wildly varying Magic Numbers.
It gets trickier…
How accurate are those inflation rates, anyway? Over the past 30 years, the government has changed the way it calculates inflation more than 20 times.
Here’s something else to consider…
What if you’re, say, 25 years from retirement? How do you factor in the Fed’s trillions in money printing over the last several years? This will certainly be an inflationary pressure. But we don’t know the extent… we’ve never experienced anything like quantitative easing before.
Given all this, here’s what we wrote in our issue…
What if you’re 20 years from retirement? How will inflation affect your anticipated monthly cash flow in 20 years? Isn’t it fair to assume you’ll need more income then just to maintain “today’s” purchasing power? For all these reasons and more, it’s critical that you run these calculations every year. |
When you run your Magic Number calculations at least once per year, it addresses inflation in a “real time” way.
You would look at your numbers—which reflect current inflation—and adjust your asset allocation strategy accordingly.
The alternative—providing you one “true” inflation rate to use in your calculations—runs the risk of being misleading.
For instance, let’s say we made a prediction: “Inflation will be 1% for the next two years.” And let’s say we were right…
Well, this would be helpful for our subscribers who were two years from retirement when we made our prediction… but what about a subscriber who was 25 years from retirement? It’s likely that the 1% rate wouldn’t be accurate for the next 25 years. So if that subscriber used 1%, it would skew his numbers.
For all these reasons, our issue suggested the “yearly checkup,” so to speak. It takes the guesswork out of inflation.
Now, all this said, Mark’s method is correct. And if you want to include an assumed inflation rate in your Magic Number calculations, it’s a good extra “safety” measure.
So we’re including an abridged version of Mark’s original commentary on inflation below. It tells you how to factor inflation into your calculations—regardless of which rate you want to use. We’re also adding it to the asset allocation issue.
You can also click here for our updated Magic Number spreadsheet. It automatically subtracts your assumed inflation rate from your projected rate of return on your investments.
But just remember—there’s a great deal of murkiness around inflation rates. For that reason, the more often you crunch your numbers, the better. It’s crucial in helping keep you on track.
Thanks to our many smart subscribers who write us, helping us address complex matters like this one.
Jeff Remsburg
Editor-in-Chief, Palm Beach Research Group
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