Archives for January 2011

The Consumer Price Index (specifically, the Consumer Price Index for All Urban Consumers) is the most common measure for inflation. But when attempting to predict how your own spending will change throughout the course of retirement, there are two reasons that historical CPI figures might not be a perfect predictor:

1. Future changes in CPI may not be similar to past changes in CPI, and
2. Your rate of spending change doesn’t necessarily match that tracked by the CPI.

What Does the CPI Track?

The CPI measures a specific bundle of goods, as determined by a survey of several-thousand families regarding their spending habits. Per the Bureau of Labor Statistics’ website, the following categories are included in the calculation. (Note: The items provided in each group are just examples. They’re not the only goods measured in that group. For the full list, see page 11 of this pdf.)

• Food and Beverages (breakfast cereal, milk, coffee, chicken, wine, full service meals, snacks)
• Housing (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
• Apparel (men’s shirts and sweaters, women’s dresses, jewelry)
• Transportation (new vehicles, airline fares, gasoline, motor vehicle insurance)
• Medical Care (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
• Recreation (televisions, toys, pets and pet products, sports equipment, admissions)
• Education and Communication (college tuition, postage, telephone services, computer software and accessories)
• Other Goods and Services (tobacco and smoking products, haircuts and other personal services, funeral expenses).

Those may not be the goods that you spend money on. For example, as somebody who doesn’t own a car, doesn’t use any prescription drugs at the moment, doesn’t smoke, cuts his own hair, and has a rather unusual diet (vegetarian, gluten-free), the CPI isn’t exactly a perfect fit for my own spending habits.

Of course, you may look at my spending choices and think, “Wow, what a weirdo!” But that’s the point. We all spend money on different things.

Even if you do buy most of the goods/services tracked by the CPI, it’s entirely possible that your allocation between those goods/services is significantly different from the allocation used to calculate the index.

Consumption Changes vs. Price Changes

When attempting to determine how much income you need in retirement, it’s also important to remember that your consumption might change, not just the prices of the things you buy.

For example, the price of prescription drugs might increase by 5% per year, but if the rate at which you’re taking them is doubling every five years, then your own prescription drug spending will be growing faster than the rate of change that’s reported by the CPI.

Predicting Your Personal Rate of Inflation

My point here is not that the CPI is useless or that it’s way off base for everybody. Neither of those statements is true. But there is a chance that it won’t align very well with your own rate of spending change.

If you want the most precise answer possible as to how your spending will change over time, my suggestion would be to:

1. Track your current spending (broken down by category),
2. Do your best to estimate how your rate of consumption will change for each category, then
3. Try to estimate how the prices for each category will change.

Longtime Oblivious Investor reader Larry recently pointed me to an article from Kiplinger in which the author suggests that people save 10.6-times their annual salary before retiring.

Statements like that drive me crazy.

It makes no sense to make retirement savings suggestions in terms of years of income. Rather, we need to measure in terms of spending.

For example, consider two investors, both starting to approach retirement age:

• Investor A has a $65,000 annual income, and he is saving $5,000 per year.
• Investor B has a $65,000 annual income, and she is saving $15,000 per year.

In order to retire without a change in living standard, Investor A needs to fund $60,000 in annual spending, while Investor B only needs to fund $50,000. (We’re ignoring taxes for the moment.) In other words, Investor A will need 20% more money saved than Investor B, even though their incomes are the same.

The suggestion that the two investors should each save the same amount of money (10.6-times their annual income) either understates A’s need for savings, overstates B’s need for savings, or both.

The Best (More Time-Consuming) Approach

The best approach to projecting your retirement spending is to go through your last year of bank statements, credit card statements, and pay stubs, tallying up your current spending in each budget category (food, medical, housing, etc.). From there, you can do your best to estimate how each spending category will change as you move into (and through) retirement.

The Quick and Dirty Approach

I know from experience, however, that many people don’t want to take the time to do the above analysis. In that case, I’d suggest at least doing the following calculation:

1. How much did you earn last year (net of taxes)?
2. Subtract the amount you saved over the course of the year. (Not the change in your account values, just the amount you actually put into those accounts.)
3. Subtract the amount of debt you paid off.
4. Add the amount of new debt that you took on.

The total is how much money you spent over the last year. Again, from there, you should do your best to estimate how each category of spending will change as you move into (and through) retirement. (Naturally, this is somewhat less precise than it would be if you had the category-by-category spending totals provided by the more thorough method described above.)

Then, once you know how much you expect to spend each year in retirement, you can start the process of determining how much money you need saved for retirement.