Economic Outlook Financial Planning Uncategorized

Inflation Adjusted Spending Plan

The rising cost of goods and services has many folks concerned, and some folks down right panicked. Historic inflation is making headlines and rightly so. As this article is being penned, inflation is at a 41-year high. May 2022 year over year inflation was 8.6%, and Core CPI which excludes volatile food and energy costs that was up 6%. Food expenses increased 10% year over year, and fuel oil costs doubled. Shelter costs were up 5.5%.

The average year-over-year inflation rate between 2000 and 2020 was just under 2.25%, and only about 1.73% on average over the past 10 years. It’s easy to forget how corrosive inflation can be on your spending power with historically low figures like this. We may have even become a bit complacent to lower than historically normal inflation rates.

However, now that inflation has been topping 8%, it is hard to ignore. You feel it everywhere you go. No one (except perhaps ultra-wealthy Americans) seem to be immune to it.

Historically high increases to daily living have been going on for nearly a year. What was once considered by many economic experts and political figures to be a transitory issue brought on by supply chain interferences resulting from Covid-19 related disruptions are now being seen as more sustained and long-term issue. Treasury Secretary Janet Yellen even recently (and very publicly) admitted to getting it wrong.

Consumers are really starting to feel it too. Their grocery bag isn’t quite as full as it was a year ago. When they fill up their fuel tank at the local convenient store and seeing that the total bill is 50% more than it was 6 months ago it is harder and harder to shrug off.

On a personal level it really hit home recently. I overheard my mother talking to my nephew. She was trying to explain to him about how things were “going to get tight for his mother.” Like any 10-year old boy he has an endless list of things he wants. Listening to his grandmother educate him on how my sister (a single mother raising two school-age children and working hard to give them the best life she possibly can) is going to have to spend more on the things they need and have less for what he may want was a punch in the gut. 

What is causing current inflation?

Inflation is caused when demand outpaces supply. In other words, too much money is chasing after too few goods and services. The result is increased prices.

Inflation and deflation are symptoms supply and demand economic principles. When there’s fewer available units of a particular item, and more people with available currency who want to pay for it, the cost of the item will go up.

If the demand doesn’t decrease (AKA: demand destruction), or readily available supplies don’t increase fast enough, prices tend to rise and sometimes rapidly as the market searches for an equilibrium. These are basic principles taught in the macroeconomics 101 class that I took during my first year at Simpson College.

There’s another side to the supply and demand issue. The money supply was dramatically increased through Covid relief spending bills which flooded our economy with more dollars. Placing trillions of dollars in the hands of Americans so that they could continue to buy stuff (increase demand) while lower supplies were made available now resulted in extraordinary inflation. American taxpayers with money in their hands, and a low supply because of a breakdown in the supply chain and manufacturing results in higher prices. We can get distracted arguing about the actions taken by our political class in the past few years leading up to and throughout the Covid-19 pandemic, or the causes of global supply chain issues and how best to correct them in the future. Nevertheless, don’t let these discussions cloud your understanding of the basic principles that have led us to this point.

How does inflation impact your savings?

Inflation impacts more than just the cost of goods and services that you buy. It also has a dramatic impact on your personal savings. As the price of goods and services rise the value of your money decreases. If your money is not working for you efficiently, inflation will erode your purchasing power. 

Cash and Equivalents

Passbook savings accounts, checking accounts, and money markets are generally hit the hardest by inflation. The value of your cash positions (assuming you’re earning little to no interest) decreases at a similar rate as inflation increases. If you have a passbook savings account, and it’s not earning any interest at all, you’re actually losing significant purchasing power year-over-year. For example, a savings account with a balance of $1,000 a year ago may still have $1,000 in it today, but realistically you can only buy about $920 worth of goods and services compared to last year. That’s effectively an 8% loss.

Fixed Income: Bonds and Other Debt Ownership

If you own fixed income assets like bonds you are likely doing better than cash. After all, your likely earning yield albeit perhaps low. That’s better than holding cash. However, the yield on previously issued bonds is nowhere near the current pace of inflation.

You may have also noticed that the value of fixed income assets has decreased. This is because fixed income assets have an inverse relationship to interest rates. As interest rates fall, fixed income assets prices rise.   When interest rate rise, the fixed income market prices tend to suffer.

Periods marked by high inflation often result in interest rates rising. This is because investors hold out (or demand) a higher interest rate before they are willing to tie up their money for long periods of time buying corporate and US debt. When interest rates rise it puts downward pressure on the value of your current fixed income portfolio. Longer-term, high-quality fixed income like investment grade cooperate bonds and US treasuries are generally hit particularly hard because they are highly sensitive to changes in interest rates.

As interest rates rise, previously-issued lower-yielding fixed income assets lose value. For example, if a $100,000 bond portfolio is yielding 2% or $2,000 per year selling them in this environment with new bond yields around 4% would likely result in a significant loss. Meanwhile, the $2,000 income from these assets is also not able to purchase as many goods and services as it would have been able to a year prior.

Equites: Stock Ownership of Companies 

Equities (stock) market investments may see volatile prices fluctuations as the market searches for valuations that better reflect the current economic outlook and future company earnings potential. Long-term however, stock ownership historically results in a more realistic opportunity to keep up with the pace of inflation. Owning shares in companies making products that people need or want to buy (and the resulting profits and growth) is often a better position to be in during times of inflation. As recipients of the dollars flowing in from higher demand these companies may see profits and growth increase.

More specifically, companies that make consumer staples like food products, household goods, and hygiene products are likely to continue to be in demand. They make things people need in order to maintain a constant standard of living. Companies selling luxury items may see demand plummet, but they may also be able to raise their prices and those who can afford them will still want to pay the premium to own their products. Retailers with lower overhead expenses likely online retailers selling these products will also likely continue to be good investments.

What does it cost to maintain your lifestyle?

Any responsible financial professional should be inquiring about how much money a client is consuming on a monthly basis. However, too often a simple impromptu guess is taken at face value. Then the professional designs an income and investment strategy around the figures provided by the prospective client on a whim. The results can be disastrous.

Few folks like the word “budget,” but we shall should have one. Whether you are well-to-do or just getting by knowing what it cost to maintain your lifestyle on a monthly basis is one key metric that everybody should get their hands on. Without this knowledge it is extremely difficult to manage your long-term financial resources in a responsible way.

Why don’t more people do this? I think the answer is that it’s hard work. I’m sure we can all think of 10 things we’d rather be doing than tracking our personal monthly spending. In reality we only need one good excuse, not 10, to justify why we don’t do this. The task of tracking all of your monthly spending over a period of several months is also time consuming. As a result, most folks don’t do it, and have a lopsided view of what it actually costs for them maintain a current standard of living.

Difficulties aside, the exercise of putting together detailed spending plan does more than just tell you what it cost to maintain your lifestyle. The process is often insightful. If you look at your monthly spending over the last three months, you’ll begin to notice patterns, some positive and perhaps some negative ones too. You’ll begin to see where your hard-earned financial resources maybe slipping through your fingers. You might even find a subscription or two that you didn’t even know you still had, but have been paying for on a monthly basis for far too long.

Once you have your arms around your monthly spending, now you can appropriately adjust each category of spending for inflation. Some items are inflation adjusted like core consumer goods and services. Others may need to be inflated at a higher rate like healthcare spending. Some expenses like mortgage principal and interest, life insurance premiums, or a car payment may not be inflated at all. Getting a more accurate picture of your future inflation adjusted spending will help you make decisions on how to better align your financial resources.

Purpose and Timeline: PT 5 Step Process

Most of the folks that we serve at Triplett-Westendorf Financial Group share a common desire. They often tell us that they want to be able to maintain a comfortable standard of living, one which they have become accustom to, throughout their retirement years. That is why we implemented an inflation-adjusted spending plan into the Triplett-Westendorf Purpose & Timeline (PT) 5 Step Financial Planning Process from the very beginning.

We recognized early on the importance of organizing someone’s financial resources, both income and assets, around a strategy targeted at producing a desired standard of living adjustment for inflation, taxes, and healthcare.

We know that we cannot predict future inflation rates, but we know inflation is a real threat to someone’s ability to maintain a desired standard of living during a retirement that is likely to last decades.

Failing to plan for it, is simply planning to fail. It would be inexcusable for us not to ask the people we serve to put in the work to help us develop a spending plan that accurately reflects their lifestyle today so that we can project inflation adjusted spending before recommending any actions, financial products, or investments.

We believe that putting in the hard work to develop an accurate spending plan and updating it annually is worth it in the long run. This is because it allows the people that we serve to see whether or not they have adequate financial resources before making the transition into retirement, and where their resources should be allocated in order to give them the best shot at living out their desired retirement vision.