What is inflation?
“Inflation is an increase in the level of prices of the goods and services that a household buy. It is measured as the rate of change of prices” (RBA 2020). So, in general, it means that the cost of living rises over time. Because it affects your cost of living, it will also affect your plans for financial independence, which is something I’d like to discuss in this article. If you’d like to get up to speed with inflation basics the RBA has a great explainer available at this link.
Let’s take the example of a household with a $100,000 take home income and a 40% savings rate. This means that they will require $60,000/0.04 = $1.5m to retire using the 4% rule. If we assume that their portfolio returns 7% p.a. their retirement journey will look something like this:
The modelling implies that it will take a little over 23 years for their portfolio to reach a size such that their cost of living ($60,000) will be equivalent to 4% of their portfolio size. This assumes that their cost of living will remain at $60,000, however we know that due to inflation their cost of living is likely to increase. So, for our new model, let’s add in a couple more assumptions
Rate of inflation is 2.5%
The household receives a pay rise of 2.5% each year
The situation is now as follows:
In this revised situation where inflation is 2.5% it actually takes around 4 years longer to achieve financial independence. The model shows that in 28 years’ time their required cost of living will rise to $108,524 which means that they will require a $108,524/0.04 = $2,713,100 portfolio.
A complex problem
While a target inflation rate of between 2 and 3% is a good starting point for modelling household cost of living increases, achieving financial independence/retiring is a complex problem that has many variables. This implies that the assumptions that I’ve made for the model will not illustrate your own experience accurately.
Inflation rate
In the example above, I’ve chosen 2.5% to be the inflation rate because it is midway between the RBA’s target of maintaining inflation levels of between 2 and 3% (RBA 2020). How this plays out in the future is anyone’s guess.
Increases in income
You’ve probably also noticed that I’ve set the increases in household income to be equal to that of inflation, once again, this may not be accurate. If you’re someone who is dedicated to working hard to increase your income growth is likely to be much higher. Many people I know are on salaries that are double or even triple the salaries that they earned when they first left school – at my current age this would put their annualized pay rises closer to 10% p.a.
Cost of living is unique
The consumer price index (CPI) is used as an indicator of inflation and is measured by the changes in the prices of goods and services consumed by households (RBA 2020). There are a whole host of reasons why this may be inaccurate for your particular situation, but the biggest of which is that the basket of goods that the RBA collects price data on is unlikely to represent your household’s unique consumption patterns.
When doing your own modelling, arguably, what is more important than looking at CPI is to track your own cash flow. This will give you an understanding what your own cost of living is as well as how it changes over the years and a better idea of how much money you’ll need to become financially independent.
Further to this, your spending patterns during retirement may actually be less than when you are working full time. Consider the amount of money that you spend on yourself to allow you to work your job; you may have to buy work clothes; have them laundered; and commute to and from work. Further to this, consider the unaccounted cost of all of the convenience items that you buy as a result of not having enough time to do things yourself.
Lifestyle inflation
In my opinion, excessive lifestyle inflation is very dangerous when it comes to becoming financially independent. It is especially the case if it means that your cost of living is increasing faster than your income as it will result in a decreased savings rate. As we know, your savings rate is possibly the most important factor in determining how quickly you can reach financial independence.
Key takeaways
- Inflation tends to increase the time it takes to achieve financial independence by causing a household’s cost of living to increase over time – this means that a household will need to accumulate more assets to satisfy the 4% rule.
- You can use historical CPI data as a basis for modelling cost of living increases but it is more important to understand your own situation and model accordingly
- Work on increasing your savings rate through a combination of increasing income and controlling spending
Engineer your freedom
References
RBA, 2020, Measures of Consumer Prince Inflation, RBA, last accessed 23/5/2020, <https://www.rba.gov.au/inflation/measures-cpi.html>
RBA, 2020, Inflation and its Measurement, RBA, last accessed 24/5/2020, <https://www.rba.gov.au/education/resources/explainers/inflation-and-its-measurement.html>
RBA, 2020, Inflation Target, RBA, last accessed 26/5/2020, <https://rba.gov.au/inflation/inflation-target.html>