What Is the Inflation Rate to Be Used for Retirement Planning
In my previous article Calculate Your Regular Expenses - The First Step of Financial Planning, I illustrated how to calculate the annual expenses for a person after retirement. That number is calculated based on the current price of goods. To calculate the annual expenses for a person after retirement based on the price of goods at the retirement age, we need to use the formula below to include the effect of inflation:
In this formula, F is the annual expenses for a person after retirement based on the price of goods at the retirement age, P is the annual expenses for a person after retirement based on the current price of goods, I is the estimated average inflation rate per annum, and n is the number of years from now to one’s retirement age.
According to the formula, when P and n are fixed, a small change in I will have a significantly amplified effect on F. Assuming P = $100,000 and n = 30. When I = 2%, F = $181,136; when I = 2.1%, F = $186,540. Here I increases by 0.1%, resulting in $5,404 increase on F (i.e. 3.0% change on F). Since I is an estimated value, it becomes a primary issue to select a proper I value in retirement planning.
Basics on Inflation
To understand inflation, in the first place we need to understand Consumer Price Index (CPI). Under the definition of CPI, there is a fixed basket of consumption goods and services commonly purchased by the households, and there is a year as base year. Get the ratio of the current price of the basket to the price of the basket in the base year, multiply it by 100, we obtain the current CPI. CPI reflects the price level for households on daily consumption. And inflation is the rate of change of CPI between two time points.
Basic Background of Inflation in Singapore
Analysing the data provided by Singapore Department of Statistics (DOS), we can gain a deeper understanding about the CPI and inflation in Singapore.
The consumption habit for Singapore households changed over time, so the fixed basket of consumption goods and services under CPI definition needs to adapt to such changes accordingly. The current basket is the version updated in 2014, which includes 10 main divisions: Food, Clothing & Footwear, Housing & Utilities, Household Durables & Services, Health Care, Transport, Communication, Recreation & Culture, Education and Miscellaneous Goods & Services. We need to take note that the CPI excludes non-consumption expenditures, such as loan payments, income taxes, purchase of houses, shares and other financial assets.
DOS collects data, calculates and publishes CPI on a monthly basis. The yearly index is derived by taking a simple average of the 12 months’ indices for the year. Likewise, the annual inflation rate for any year is computed by taking the ratio of the index for the current year compared with that of the preceding year.
Select among Three CPIs
On DOS website, there are three different CPIs. Their differences are on the basket of consumption goods and services.
The first index is All Items CPI, which covers the full basket under the 2014 definition.
The second index is All Items less imputed rentals on OOA (owner-occupied accommodation). It excludes imputed rentals on owner-occupied accommodation from the basket. Why is there such a weird item as “imputed rentals on owner-occupied accommodation”? Because in the full basket, it assumes that every household need to pay rental on the house where they stay. If the household are renting a place, the rental is paid to the landlord. If the household are the owner of the place where they stay, the rental is paid to themselves. However, this imputed rental is not actual cash expenditure. So this index is compiled as an additional indicator.
The third index is MAS Core Inflation. It excludes the components of “Accommodation” and “Private Road Transport” from the full basket. The price of these two components usually fluctuates during a short term. As a result, Monetary Authority of Singapore (MAS) uses this index to reduce the effects of short-term fluctuation, in order to work out long-term economic policies.
Because most Singapore residents will stay in their own house upon retirement, the second index is the most suitable among the three to be used when we estimate the annual expenses for a person after retirement based on the price of goods at the retirement age.
Historical Data and Average Value of Inflation Rate
In the data provided by DOS, CPI based on All Items less imputed rentals on OOA is available only from 2008 onwards. As a result, the corresponding inflation rate data is available from 2009 till last year 2019, which is tabulated as follows:
From the table we can see that the inflation rates can vary a lot between different years. From 2009 to 2019, the highest is 4.2%, the lowest is -0.4%, and most of the values drop between 0 to 2%.
During retirement planning, we need to estimate the average inflation rate in the future. Based on experience, I think the average inflation rate in the past 10 years is a proper estimation of the average inflation rate in the future. Because by the smoothening effect it avoids values that are either too high or too low due to short-term fluctuations, and at the same time it is a value based on recent historical data, which is more relevant to the future value.
Since the inflation rate is a rate of change of the CPI, geometric mean is used in calculation. The calculation is simple. It is 2020 this year. The average inflation rate in the past 10 years is the ratio of the CPI in 2019 to the CPI in 2009, getting its 10th root, and then minus 1. In the data provided by DOS, Year 2019 is the base year, so CPI is 100. The CPI based on All Items less imputed rentals on OOA in 2009 is 83.387. After calculation, we get the average inflation rate in the past 10 years as 1.83%. When we do retirement planning in 2020, we can substitute 1.83% into I in the formula at the beginning of this article.
Update the Plan Every Year
Retirement planning needs a review every year. Just to take the formula F = P (1 + I)^n as an example. When one’s consumption habit changes, P will change. When a year passes, the average inflation rate in the past 10 years needs to be updated, so I will also change. Moreover, the person is one more year closer to the retirement age. When n decreases, our estimation of the annual expenses for a person after retirement based on the price of goods at the retirement age will be more accurate.
As an important indicator in Macroeconomics, there are many more topics on inflation. On the other hand, retirement planning is also an essential part of personal financial planning. If you have any interesting questions, welcome contacting me for a discussion.