Adam Leci explains to advisers how to stop worrying and love inflation
Recently, I have seen some worrying posts on social media as well as receiving a number of phone calls and emails from concerned advisers. Why? Headlines such as ‘Inflation reaches 30-year high’ are provoking clients into challenging the inflation assumptions their advisers use in cashflow models.
While the adviser knows they are right, perhaps they are struggling to justify to clients that it is appropriate still to use, for example, an inflation figure of 3% when inflation is sitting at nearly three times that mark.
It is important to remember that cashflow models are long-term illustrations of one potential financial future. The assumptions we make in our models should reflect this. Let’s look at the justification behind the assumptions you choose.
Long-term inflation trends: If you are projecting 20, 30, even 40-plus years of a client’s future, it is sensible to look at what inflation has been doing in a similar period. I have chosen to use the Retail Price Index (RPI) and, as a yardstick, the 30-year average of the RPI is 2.827% (see chart 1).
As you can see, it has been a pretty volatile 30 years. RPI has been as low as -1.6% and (of course) as high as 8.2% (February 2022). But the thing about long-term trends is that they change slowly, a bit like a freight ship turning around. Chart 2 shows the rolling 30-year average of the RPI looks like, during the same period.
You can see the little tiny uptick at the end as the long-term average is trending back towards 3%.
Short term vs long term
So, what is going to happen in the next couple of years and how will or should that impact what we do with clients’ cashflow models?
The Office for Budget Responsibility (OBR) has forecast that the Consumer Prices Index (CPI) will peak at 8.7% in the final quarter of 2022. If RPI continues to trend a couple of percent above CPI, this could mean RPI rates of nearly 11%.
But (and it’s a big ‘but’), both the OBR and the Office for National Statistics (ONS) agree that inflation will return to the Monetary Policy Committee’s (MPC) target of 2% within the next 12 months. The ONS predicts that standards of living in the UK will take their biggest hit since 1956. However, this is not due to a long-term trend, it is due to a short-term shock.
What we are experiencing at the moment is a large disparity between earnings indexation and inflation. Would it be sensible to assume a long-term inflation rate of 8.7%, purely because that is where inflation is predicted to peak? Would it be sensible to assume your client’s earnings will only grow at 0.5% a year for the next 15 years, because that’s the pay increase they received this year?
By all means, show clients the impact of ‘what if inflation were higher’, but that does not mean this should form the basis of your advice.
I would recommend showing clients the potential impact of a long-term shift in inflation rates as a hypothetical: “Here’s a scenario where inflation is 3.5% or 4%, rather than 3%, and how it might impact your standard of living.” (see Chart 3).
While the adviser knows they are right, perhaps they are struggling to justify to clients that it is appropriate still to use, for example, an inflation figure of 3% when inflation is sitting at nearly three times that mark
But I do not think it is reasonable now to make long-term changes based on what is ultimately a very short-term trend.
So, how long should we wait?
Well, consider a scenario where inflation stays at the current level of 8.2% forever and another where it increases to 10% and stays there. How long do you think it will take before we see an impact on that 2.827% figure?
For my baseline, ‘inflation returns to normal’, I have followed the government’s projections. I have assumed RPI continues to grow at 0.5% a month until it reaches 10.7% (2% above CPI projections), then falls by 0.5% a month until it returns to the MPC’s long-term target of 2.5%.
If inflation were to stay at the current level of 8.2% and stay there, it would take:
- 14 months to reach a rolling 30-year average of 3% (mid-2023).
- 80 months to reach a rolling 30-year average of 4% (late 2028).
- 140 months to reach a rolling 30-year average of 5% (late 2033).
If inflation were to increase to 10% and stay there, it would take:
- 11 months to reach a rolling 30-year average of 3% (early 2023).
- 59 months to reach a rolling 30-year average of 4% (early 2027).
- 108 months to reach a rolling 30-year average of 5% (early 2031).
The same information is displayed in the table below.
So what?
- Inflation is unlikely to remain at more than 8% for the long term.
- I have heard (and seen) examples of advisers using 8% inflation figures in cashflow models. But the data above shows that we would need current levels of inflation to persist for nearly 30 years (28 years and eight months, to be precise) before the long-term average for inflation gets to more than 8%.
Bearing in mind just how detrimental a force long-term inflation can be on a client’s cashflow, showing them the impact of their cost of living compounding at 8% a year while their investments grow at, for example, 5% for 40 years (-3% real return) will almost certainly paint a highly pessimistic picture of their financial futures.
So now, when a client calls worried about the latest headlines on financial markets, you tell them to hold tight and explain the long-term vision. Why should inflation be any different?
That said, we do need to keep a close eye on things. If inflation creeps even higher, there is a very real chance that by next year, your 3% inflation assumption could be a little on the low side. If things stay that way for around another six years, then maybe it would be prudent to increase your inflation assumption. But only by 1%, not 5%.
In short: please don’t adjust your cashflow models to use an inflation rate of 8%. At least, not yet.
A caveat
This article is my opinion, based on mathematical projections of average inflation rates without any consideration of the macroeconomic and socioeconomic factors at play. It is intended to help advisers justify their modelling assumptions, when challenged by clients, and to make sensible long-term assumptions in an unprecedented time.
A long-term rolling average is not the only fair measure or justification for inflation assumptions in a long-term cashflow projection. You can, of course, use whatever assumptions you like, providing you justify them to your clients.
Adam Leci is technical consultant of Prestwood Software
