Does Inflation Affect Me?
Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.
When investing, very often we concern ourselves with visible risks —
Will the market collapse -30% like it did last year?
Will Asian stocks crash if the US and China get into another trade war?
What happens to my money if this company defaults on its bonds?
These are some common worries and refrains.
However, amongst the numerous risks facing investors, inflation is a silent killer. If you do not manage your money and savings well, it will slowly push your desired/ideal lifestyle out of reach. The infographic shown below from a local blog site shows the significant rise in prices over the years. The problem is that inflation occurs at a slow pace causing most of us to overlook it.
The runaway inflation of the early 70s and 80s is not likely to occur again, but the chance of sustained rates above the 2% level is possible. Data from Department of Statistics shows that Singapore has experienced double digit inflation before as shown in the chart below. The younger generation with high human capital, still in the workforce and generating income, may not have much to worry about. However, retirees who need to live off their accumulated assets should consider how higher inflation could impact their financial situation and spending, and evaluate what are the best actions to counteract its effects.
For example, does your budget mainly cover basic necessities like food and medicine, or would you want a little extra for luxuries? Depending on your preferences, you’ll have different reactions to inflation risk and how you want to address it.
Inflation is Increasing. How Does it Affect Me?
Everyone experiences inflation differently. For example, you may read that inflation is up 4% from 1 year ago, but that doesn’t mean everyone spent 4% more on goods and services across the board. Certain items will be severely impacted, while others will stay closer to baseline assumptions. The simple illustration below, taken from SingStat’s CPI paper, shows that costs in different households rise differently depending on what they spend their money on.
In Singapore, the items with the highest increase in costs since the 2000s are:
Education (+81%)
Health Care (+58%)
Food (+50%)
There are some items that experienced a very minimal increase in costs over the years, such as clothing and communications. Perhaps we have Uniqlo and the variety of virtual telcos to thank for.
However, if your consumption consists largely of these higher cost items, then you will be feeling the pinch. Of course, this pattern may not always be consistent (education costs won’t go up forever), but it highlights that inflation isn’t some broad-based impact to all investors, and can affect individuals differently.
What Can You Do About The Impact of Inflation on my Retirement?
Generally, you have two options at your disposal to combat inflation risk:
Portfolio adjustments
Spending adjustments
Portfolio adjustments include building and allocating a portfolio with inflation adjusted assets like stocks and commodities, and reduced bond exposure. Spending adjustments focus on rule-based approaches to keep spending in check (after adjusting for inflation).
While portfolio adjustments get more of the attention, spending adjustments are likely to be more predictable and more impactful over time. They also have the advantage of working in all market conditions, whether markets are up or down.
A simple simulation conducted below on a $1M GYC VaR 10 portfolio with an initial payout 4.2% per annum over 30 years, shows the outcome of the various options described below on a portfolio’s end value in the face of escalating inflation. Various scenarios of long-term inflation were studied, from 0% to 5%.
The first option is for the investor to do nothing.
The second option is for the investor to incrementally reduce spending for every % point gain in inflation.
The third option is to tweak the portfolio to incrementally include more equities as inflation rises.
The fourth option is a combination of options 2 & 3.
From the diagram you can see that the do nothing option introduces the highest uncertainty to the end value of the portfolio — in an extreme case, the investor runs out of money. Portfolio changes do help somewhat but also have a higher degree of variance — as we tweak portfolios and include assets which can keep up with inflation, we inevitably introduce more volatility into the portfolio. While spending changes do help the portfolio end value, a combination of portfolio and spending tweaks provide the best outcome.
In the end, there is no “fire and forget” method that can be implemented to ensure that you hit your goals in the future. This is where the value of an advisor comes in. Sitting down to discuss small reductions in payout and minor tweaks in times of duress can increase the chance that one’s portfolio doesn’t run out prematurely; you can always choose to reset your spending levels to some degree or narrow your adjustments once the storm is past.
For the vast majority of us, a well-diversified portfolio will continue to act as an “all-weather” portfolio that serves to combat (but not avoid) a number of market and economic shocks over the long-run. An advisor can then help you determine how to allocate your assets to best address the impacts of inflation and other complex planning issues.
