Many ways to count inflation: Whats a financial adviser or retiree to do?
When financial advisers are working with clients to figure out their retirement strategy, they need to factor in inflation into the mix. But the question is, how does one decide what inflation is likely to be years into the future when there are so many different ways to measure it even in the present?
When Raymond James Financial Services advisers evaluate clients’ retirement needs these days, they tend to plug a figure of 3% annual inflation into the platform’s financial planning software before embarking on their clients' various retirement planning and retirement income strategies.
Individual Raymond James advisers are free to revise that number up or down depending on their own analyses of likely inflation in the coming years, a Raymond James spokeswoman tells Financial Planning. But the number itself is based upon a melding of two figures: a Department of Labor index for the 10-year span between 2000-2009 and another Labor Department average retail price index for the period from 1972-2009, which shows an annual inflation rate of 4.55%.
Figuring out what the inflation rate is likely to be a year or two years, or a decade or two decades hence, it would seem, is a matter of guesswork.
Truth is, it’s not even that easy to come up with an answer to what the inflation rate is right now.
As it is, there are three major measures of inflation.
The most commonly cited of these is the CPI-U, for Consumer Price Index-Urban, which is also known as the “headline” CPI, because it is the one reported out once a month by the Bureau of Labor Statistics. Based upon a monthly survey of 40,000 suburban and urban households, this number includes some 80,000 commonly purchased goods and services, variously weighted, and is said to be representative of the spending habits of 87% of the American population.
Then there is the so-called core CPI. This figure is used by the Federal Reserve in its deliberations about fiscal policy and interest rates. The difference between the core CPI and the CPI-U is that the core CPI takes out food prices and energy prices, on the theory that these both move rapidly both up and down and do not actually provide an accurate picture, at least over the shorter term, of long-term price trends.
The difference between the two figures can be quite substantial. For example, the CPI-U claims that prices have risen by 3.6% over the past 12 months, while the core CPI, taking out food and energy increases - both of which have been substantial over the period — claims inflation for the past 12 months has been running at just 0.3%.
From the Fed’s point of view, it might make sense to say that prices are not rising much overall, so there’s no need to worry about inflation right now. That allows the Fed to hold off on any interest rate hikes, which it would certainly feel a more urgent need to consider if it thought inflation were rising to a rate approaching 4%.
But for the average American, the notion that the cost of living has only risen by 0.3% since this time last year sounds ludicrous. Of course that’s because they’re going into the supermarket and to the gas pump almost daily and see the prices rising.
There is a third inflation measure, the so-called "chained CPI," and it’s one that’s getting a lot of attention lately because many conservative economists and politicians are arguing it should be used instead of the CPI-U to determine increases in retirees’ Social Security checks.
The chained CPI tries to account for a common behavior of consumers, which is essentially the fact that when faced with higher prices for goods and services, many turn to cheaper versions of the same thing. Quality may go down, but what the consumer actually spends is lower.
For example, if beef prices rise, many consumers will turn to pork or chicken. If the price of cars rises, many people will buy smaller cars or used cars. When food prices rise broadly, consumers will forego name brand products and buy store brands.
But this is still only part of the story.
Retirees present a special case when it comes to inflation.
The biggest factor that is different for them is that they tend to spend a much greater percentage of their annual budget on health care. And even though they are eligible for Medicare after they reach 65, Medicare hardly covers all of the medical bills of the elderly.
Most need to buy MediGap insurance, premiums for which have risen sharply in recent years.
Then there are the things that no insurance covers: in-home care, nursing home care, the cost of children who have to come and help out, trips to the doctor, wheeled “bicycle-type” walkers, motorized carts for those unable to walk, medically required alterations to the home, etc.
It can all add up to thousands of dollars — even tens of thousands of dollars — per year.
According to Standard & Poor's for instance, medical costs in 2010 rose at a rate of over 7%, or at roughly double the rate of the CPI-U for the year.
Now medical costs are part of the market-basket of goods and services factored into the CPI-U, as well as the other two most commonly-used price indexes. But that doesn’t help if you are elderly and medical care costs are a much bigger part of your budget — especially if the Social Security Administration isn’t making that adjustment in calculating how much to raise your benefit payment the next year. And, it doesn’t.
No wonder the Raymond James advisers skip the whole batch of current CPI indexes and go with old historic numbers covering a long period of time.
— Dave Lindorff writes for Financial Planning, a SourceMedia publication.