April 26, 2021

Inflation has added effect on your financial plan

Inflation is the quantitative measure of how quickly the price of goods is increasing. The…

Inflation is the quantitative measure of how quickly the price of goods is increasing. The most common measure used to quantify this is the consumer price index, or CPI, which is determined by tracking the weighted average price for a basket of goods. This “basket” is made up of consumer goods and services such as food, medical care and transportation costs. The price changes reflected in that basket of goods are meant to assess the changes in cost of living for consumers. When we build financial plans for clients, there are a lot of variables to take into consideration, and many of them can be hard to accurately forecast. Inflation, and its role in a long-term plan, is a great example of this.

Over the past decade, inflation has been historically low, though this may be changing due to the unprecedented stimulus, monetary response and eventual global financial recovery from the COVID-19 pandemic. It is possible that inflation could begin to rise, which is meaningful as we plan for the future, because inflation causes two harmful effects on one’s savings.

The first is that increased inflation means that purchasing power is reduced at a quicker rate.

The second is that, as future goals become more expensive because of inflation, more stress is applied to your portfolio to support those increased spending needs.

For those reasons, it’s important that we stress test the impact of inflation when we run our financial plans. This can include adjustments in future spending assumptions or target balance accumulation objectives to build in higher margins of safety.

Another area of consideration when addressing inflation in the planning process is examining asset allocation and the impact that adjustments can have on the probability of success. As the value of a dollar declines over time, investing for growth provides much of the returns needed to maintain and even grow purchasing power.

Even in the uncertain times we have seen over the past year, it’s important to evaluate your portfolio’s sensitivity to potential inflation increases and adjust your allocation where needed so that your investments can adequately maintain your purchasing power. Everyone has a different level of risk tolerance for adjustments like this, but understanding the proper mix of risk and growth assets that allow your plan to succeed, including the use of alternative investments, is essential. This measured approach is more important than ever as life expectancies have risen over time, leading to a longer timeline that our assets must fend off inflation and continue to support our lifestyles.

Every financial plan is built on unique and customized goals and expectations. Each case has a different need for risk and growth but, as we face global changes ahead, the impact of inflation will certainly continue to play a role in how we think about preparing for the future, our investments, expected real rates of return and risk.

King is a vice president and financial planner at Ancora.