Is inflation irrelevant in financial planning? Pt. 1

By Roccy Defrancesco

The Wealth Preservation Institute

Once the client's risk tolerance has been decided, inflation is irrelevant when discussing whether to allocate a client's money into stocks, mutual funds, bonds, fixed annuities, or other wealth-building tools to use in retirement.

Stereotyping financial planners (FPs)--what's the stereotype of an FP? An advisor with one or more securities licenses (or an RIA) who believes the best way to grow money is through the use of a "properly balanced mix of stocks, bonds, and mutual funds."

The stereotype also includes my belief that most securities licensed advisors and RIAs do not understand the proper use of fixed indexed annuities (FIAs) as protective wealth-building tools.

What is inflation? Inflation is when the prices of most goods and services continue to creep upward. It is measured by the Consumer Price Index. For example, gas in 1988 cost $1.08. Today it costs $2.80.

Continuing the stereotype -- a typical financial planner sits down with a client and asks many questions including:
  • How many years until you want to retire?
  • In today's dollars, how much do you need each year after tax to live on when you retire?
  • How long do you think you will live?
  • What do you expect as an average rate of return over the next 30 years?
  • How much money do you have right now to invest for your retirement?
  • What is your investment risk tolerance?
Using an example 65-year-old client, assume the answers to the above questions are:
  • 5 years
  • I have no idea; but if I were to guess, I'd say $30,000 a year pre-tax
  • I have no idea; but if I were to guess, 95
  • 6 percent
  • $310,000 (in a 401(k) plan)
  • Conservative
Most FPs today will use as an "aggressive" rate of return (ROR) of 9 percent to 10 percent (gross), 7 percent to 8 percent as a "moderate" ROR, and 4 percent to 5 percent as a "conservative ROR. Annual expenses (mutual fund expenses, FP fee, etc.) in a 401(k) plan managed by an FP will range from 1.5 percent to more than 3 percent a year.

Question: How is the typical FP going to help this client reach his/her retirement goal of $30,000 pre-tax every year in retirement (using only the 401(k) money)?

In order to be able to remove $30,000 pre-tax every year from the 401(k) (or IRA after the client retires in 5 years) and not run out of money before age 95, the current $310,000 401(k) account balance must grow at a gross rate of 7.5 percent every year for 30 years (netting a 6 percent ROR after applying a 1.5 percent annually for expenses).
How can an FP generate a "guaranteed" return of 7.5 percent gross every year for 30 years? Can it be done with a properly balanced mix of stocks, mutual funds, bonds, and CD/money market accounts? The answer is could happen, but it can't be guaranteed.

However, remember, this client has a conservative risk tolerance. That would mean the client won't be in stocks and mutual funds. Most FPs will counsel this client to invest in bonds and CDs/money market accounts. What are the chances that a conservative bond/CD/money market portfolio will return 7.5 percent gross throughout the next 30 years? The answer is about zero.

What about inflation?

I haven't even discussed inflation yet. Inflation over the last 30 years has been approximately 3.5% a year. Extrapolating these numbers out five years for the example client, he/she would need to withdraw $35,631 from his account at age 75 to keep up with inflation. Continuing with the extrapolation, at age 85, the client would need to withdraw $50,260 to keep up with inflation and at age 90, the amount would be $59,694.

There are three classic ways my example client is going to be able to retire in the manner he/she wants (with $30,000 in today's dollars to spend when he/she turns 70):

1. Earn a higher rate of return on money invested than a conservative portfolio will allow

2. Save more before retiring

3. Spend less in retirement

Let's assume the client can't possibly save more money over his/her next five earning years before retirement. How is the FP going to grow this client's wealth so he/she can have $30,000 a year in pre-tax income in retirement starting at age 70? In other words, how can an advisor help this client deal with inflation?

The answer is the advisor can't help this client reach his retirement goals or help him "deal with inflation" given his conservative investment philosophy and the amount of money available to grow and be used for retirement.

Let me rephrase the previous statement: The FP could try to generate the returns needed on the money in the 401(k) plan; but in order to do so, the client will have to buy stocks/mutual funds that fall into a moderate or even aggressive category (remember the client is conservative).
The inflation discussion

Once a client decides what his risk tolerance is for growing wealth for retirement, the only reasons to discuss inflation are: 1) to decide if more money needs to be saved, or 2) if the client should mentally prepare to spend less in retirement.

So, inflation is "relevant" when discussing financial planning to bring to light the reality of a client's situation. Inflation can be used to motivate clients to save more or reassess how much money they will actually have to live on (adjusted for inflation) in retirement.

What's my issue with how many FPs deal with inflation?

Many FPs use inflation as a reason for clients to invest in more aggressive investments.

Also, many FPs shun the use of fixed indexed annuities (FIAs) as a retirement tool because they say the caps "limit the products ability to keep up with inflation." In most instances, those with this opinion are wrong.

Let me state again, once a client has chosen his/her risk tolerance, inflation is irrelevant when choosing which types of investments to use.

If the client has a conservative investment stance, an FP will recommend bonds, money market/CDs, and fixed annuities.

Just because the numbers using a conservative investment philosophy won't keep the client's income up with inflation, does that mean the client should all of a sudden shift his/her investment stance to a moderate or aggressive one? No.