“Double Whammies” – by Samuel Rossouw
October 29, 2013
Beware the rearview mirror – by Andró Griessel
May 6, 2014

The hole in your bucket – by Andró Griessel

The hole in your bucket – by Andró Griessel

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It is that time of year again when everyone is curious about the forecast for the year and many try their hand at predicting the near future.  What is the Rand going to do?  What is going to happen with the gold price?  How much are Naspers and Richmont’s shares still going to rise?  When is the whole financial system going to come crashing down?  There are usually two possible answers to these types of questions – a long one and a short one.  I often catch myself giving the long one (unfortunately), while the shorter version, namely “I have no idea”, is probably the right one.  Yes, predictions have entertainment value, but are not a useful way to spend your time or energy.  Someone recently hit the nail on the head when he said: “Predicting is hard, especially when it’s about the future”.

There is, however, one prediction that I will make with confidence and that is that, in the next couple of months, you will experience an uneasy feeling that there is a hole in your financial bucket.  Even if you were recently “lucky” enough to receive an 8% salary increase, you will still develop a gnawing feeling that it simply is not enough to fill the ever increasing hole that inflation is creating.

It has bothered me for some time that we use an inflation assumption of 6% when we do financial planning for our clients (irrespective of their life stage or personal expenditure preferences).  It is one of those things that you accept as a given (since it is the government and economists who give us this rate and is therefore used as the benchmark by most planners).  Until you take the time to look at actual figures.  A recent study of Chris Becker (economist at ETM Analytics) has brought the reality home, hard and clear. The idea of inflation at 6% is but a pipedream in most people’s lives.  He looked at price increases of a basket of items between 2002 and 2012.  The results make for interesting reading.  Most of these items (except maybe Ricoffy and the Ford Ikon J) are expenses that we are all familiar with.  Please see the list below with their corresponding inflation rates over the 10 year period.

Fuel
Flour
School fees
Ricoffy
Coca Cola
Milk
Lays chips
Castle Lager
Skip washing powder
Rent (Newlands)
Ford Ikon
=
=
=
=
=
=
=
=
=
=
=
12.97% pa
12.08% pa
11.38% pa
11.27% pa
10.52% pa
9.94% pa
9.68% pa
9.42% pa
7.18% pa
7.05% pa
5.20% pa

Items that I would have liked to have included in the list above are: electricity (we all know it has increased far north of 10%); medical aid premiums (in the region of 9.5%) and the price of meat (since it is a staple food for most people reading this article).

There are very few items on this list (actually only the Ford Ikon) that had a price increase of less than 6% pa. From the above, it becomes clear that if we use 6% as a starting point for salary increases and long term financial planning while not taking into account our gradual change in spending preferences, we may very easily be caught with our proverbial pants round our ankles.

How does inflation affect you and your financial planning, and what can you do to prevent being caught off guard?  Firstly, I think that it is important to understand that we all have different inflation rates. To accept a uniform rate of inflation in financial planning is a gross generalisation.  A couple in their 40’s, with two children in school, a mortgage bond and vehicle finance payments (maybe two) will have a different inflation rate than that of a retired couple.  And you will probably not believe me when I say that the retired couple will most probably have a higher inflation rate than the couple in their 40’s, due to the nature of their expenses.  Remember that inflation is not the EXTENT of your expenses, but the RATE at which it increases every year.  See the following example of an actual pensioner’s expenses:

img1

Try not to fixate too much on the “estimated” inflation figures and whether it is 100% correct or not.  These are at best guesses for the main purpose of illustrating a point and might be slightly over or under stated.  What I want to illustrate though is that 1) 6% average inflation is probably a fairy tale for especially retired people and that 2) as I will illustrate below, inflation is often higher for retired people than for the young working class (with debt).  See an example below of an affluent couple with 2 children.  Once again, the figures are illustrative and used to prove a specific point.

img2

The couple illustrated above, has an inflation rate of slightly more than 7%.  The main reason for this is that a large component of their expenses (mortgage bond & motor finance) has not increased at all during the year, due to interest rates that have remained constant.  In some cases (while interest rates were decreasing), their inflation rate would have even been lower than the official inflation rate.  This is then also the case over the last 10 years where we saw a structural decline in interest rates.  This trend helped to keep people’s inflation rate low and vested the misconception of ever increasing wealth.  As was warned time and again in the past, this period is coming to an end.  You would do yourself a huge favour by paying closer attention to your monthly spending, especially if your family is dependent on a salary increase that are determined by someone other than yourself.

I also want to show by means of an example, what the implications are of a prolonged UNDERESTIMATION of your personal inflation, for working people and retired people alike.  Let’s start with a retired person:

Mrs Doubtflation (a widow, aged 65), inherited R3 000 000 from her late husband’s estate, from which she needs to generate enough funds to meet her current monthly expenses of R16 000.  This income has to increase annually to keep up with inflation.  She sets up an appointment with her financial adviser to calculate how long her funds will last if she withdraws R 16 000 pm and increase it annually with 6% (the inflation rate that is generally used).  Her adviser crunches the numbers (ignore tax to keep the calculation simple) and comes to the following conclusion:

img3

The planner informs Mrs Doubtflation that her funds will last for another 27 years (given that she achieves an investment return of 10% on average and her personal inflation is 6%).  She is adamant that she would be six feet under and long forgotten by then.  Everyone seems comfortable and life goes on.

Now here is the problem.  If Mrs Doubtflation’s ACTUAL inflation IS in fact 9.83% (as illustrated above), then her longevity of capital graph will look as follows:

img4

All of a sudden, her funds are completely depleted after 16 years (at age 81) and her capital decreases in nominal terms from age 71 already.

Combine the underestimation of actual inflation with a too-conservative asset allocation (for example everything invested in the bank in a fixed deposit or money market account) and the results could be catastrophic.

Back to the younger couple:  John (currently 40) tells his planner that he and his wife would one day like to earn the EQUIVALENT of R 30 000 pm in today’s terms, when they retire (at age 65).  This amount then has to preferably increase with inflation until they reach the ripe old age of 95.  The planner then works with a 6% inflation rate (as usual).  The figures that he comes up with are the following (again I’m ignoring tax to keep the calculation simple):

Inflation-adjusted income needed at retirement (65) = R128 756 pm

Capital amount needed to satisfy this need = R27.8 million

Once again, if we accept that the inflation assumption is too conservative and the couple’s ACTUAL average increase in living costs (i.e. inflation) is 8%, then the picture looks considerably different.

The inflation-adjusted income needed at retirement is = R205 454 pm
The capital amount needed to satisfy this need = R56.3 million

This 2% assumption error, means that you would need 60% more per month compared to what you thought you needed.  You would also need more than double the capital!!  This is not a minor planning error.  In practice, it means that your starting income (in today’s terms) will be around R 18 800pm instead of the R 30 000 that you planned for.  Throw in the mix an overly optimistic assumption about the rates of return that your investments are going to achieve, and the result is once again baked beans and bullybeef.

So what are you to do about this situation?

  • If you are not already doing it, start to keep a record of all your monthly expenses.  If you have never done it before, it is going to be a sobering exercise.  It may be a little bit of a relationship tester too, in more ways than one, but a very important exercise to go through nonetheless.
  • Ask your financial planner to do an estimate of your personal inflation and compare it with the assumptions that you have used until now.  If it is significantly different (more than 1% difference), redo your calculations and make the necessary adjustments to your planning.
  • Cut any unnecessary expenses, because if you cannot grow your income much more than the official inflation rate, you will have to pull in the belt this year.  If you have your own business and the profitability already seems to be under pressure compared to this time last year, you will have to take quick and decisive steps to decrease your overheads, or else you might soon find yourself in a very uncomfortable position.
  • VERY IMPORTANT:  Monitor your progress annually (with the help of your financial planner) and compare it with your goals.  It is much easier to take corrective action when you have lots of time on your side.

The End

As usual, I welcome any questions and/or feedback.  If there are any readers with access to old prices, like the cost of your first house, car or any article (preferably 10 years or more ago), please forward this information to me for the purpose of building an inflation model from ACTUAL data.  The more relevant to your current spending, the better obviously.

“Many emerging countries are facing the same issue of overheating and inflation because they have been vigorously expanding fiscal and monetary policy to counter the 2008 shock”.
Sri Mulyani Indrawati

Please contact the author (Andró Griessel) if you have any questions or comments on this month’s 2Cents.

Disclaimer: Although all possible care was taken in the drafting of this document, the factual correctness of the information contained herein cannot be guaranteed. This document does not constitute advice and anyone planning on taking any financial action based on this document, is strongly advised to first consult with their personal financial advisor. ProVérte Wealth Management is an authorised financial service provider with FSP no. 5966.

Andró Griessel
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