Vinod's Finance Page

Is Adjusting for Inflation Enough?

Imagine that you were living in America in year 1950 and earning as much as the median (50th percentile) American family did in that year. Suppose, in that same year you happen to receive a large inheritance, which your financial advisor then calculates would be enough for you to retire. His calculations shows that you can withdraw the same amount as you are earning now and adjust each year for inflation to maintain your standard of living. You decide to follow his advice and retire.

Fast forward to year 2005. You would be surprised to learn that your standard of living is now only marginally higher than that for a family living in poverty (poverty is around the 12th percentile) in America in 2005. By 1994, you would be having a standard of living around 20th percentile - poorer than 80 percent of the population. Most people would not consider this to be “maintaining” their standard of living! Why were you not able to maintain your standard of living when you are adjusting for inflation each year? Were all the personal finance books that said adjusting for inflation would maintain your standard of living wrong?

The primary reason is that the standard of living continually increases each year. In the short term this might be too small to notice but in the long term its impact is large enough to knock you down the social strata. Most people would be interested not just in maintaining a Fixed Standard of Living (FSL) but in maintaining a certain Relative Standard of Living (RSL). This simply means that most people would like to remain at roughly the same percentile level at the very least. Most would prefer to go up to a higher percentile. You want to be able to afford the conveniences and improvements made as time goes on and you want to maintain and keep up with your peer group. If this is your goal then you are really interested in maintaining a Relative Standard of Living - and adjust your annual withdrawals to reflect RSL. The above example is for someone in US but it would be an even bigger issue for someone in India.

Maintaining one’s Relative Standard of Living could be viewed as sum of three components:
1. Change in the standard of living in one's community of reference.
2. Change in the composition of goods and services one consumes due to life-cycle. As we age and go through life stages the amount, type and nature of what we consume changes.
3. Inflation on your specific set of consumption items.

Various inflation measures are only a rough approximation of item three above. By only adjusting for inflation you are only taking an approximation of one component of the three. Anyone planning to retire early with withdrawals based on this one measure would likely be very disappointed in latter years.

In addtion, there are subtle variations in how inflation is measured in different countries. US uses hedonic measures that attempt to capture some of the quality improvement in goods and makes adjustments so that inflation would show up lower than would be obtained by following Indian methodology. Say for example, new federal guidelines call for introducing an additive that costs fifty cents into gasoline to reduce emissions. This fifty cents are not treated as an increase in inflation of gas even though gas would now cost fifty cents more. Hedonic approach treats this as in increase in pleasure you get from cleaner air. Regardless of weather you approve or disapprove of this approach, this understates the inflation experienced by people.

Standard of living changes much more rapidly in a rapidly developing country like India than in a developed country like US. In addition, the increase in standard of living varies within the social strata of a country.

As with most matters in finance, the specific approach one takes to maintain a certain Relative Standard of Living (RSL) in retirement is specific to the individual circumstances. This has to be viewed in context with the need, ability and willingness to take risk. There is no one good general approach that is ideal.

Does this mean I have to calculate RSL and make adjustments on that basis?
No! This gives you a framework for thinking about the amount of money needed, the adjustments that you should be prepared for over long periods of time, and most importantly highlights the risks in your investment strategy and asset allocation. For example, I-Bonds and TIPS would protect only from one of the components that make up RSL and viewed from this perspective they are not as "safe" as one would have assumed. Similarly, an investment approach that calls for an asset allocation that is almost entirely in bonds is unlikely to ever support withdrawals that provide for RSL for an early retiree.

Who does this apply to?
This applies to anyone who is planning to retire early or planning a specific retirement amount at an early age (An Indian planning to save X amount in US to take care of retirement expenses and working to just meet expenses in India until retirement).

Why is Relative Standard of Living not given much if any mention in any of the personal finance books?
There are several reasons for this. First, most retire at an age of around 60-65 years and at 65 most would be pretty set in their ways and would not be making a lot of adjustments to their standard of living. Second, this adds additional complexity that cannot be quantitatively measured easily and most have tough time just making the leap to simple inflation adjustment. Third, the adjustment due to changing mix of services consumed have a much more impact than those due to standard of living for those above 65. This is approximated as inflation to simplify.

However, it is not like this concept is not used. You only have to look at how social security payments are adjusted each year. The people setting up social security adjustmets used a simple mechanism - adjust for wages instead of just CPI. Since wages increase faster than inflation - to reflect increases in standard of living, it provides a rough measure for adjusting payments each year.

Can we estimate the increase the standard of living?
Fortunately, yes this is easy to estimate over the long run. It is roughly equal to the real per capita GDP growth of the country. For US, it is around 2%. In India, this is going to be much higher, around 4%. This is an approximation because you need to adjust for the increase in the standard of living of your reference group - so if your group is the top 5% and the top 5% is increasing its standard of living at a faster rate then the rest of the country, you need to adjust for that higher figure.