Returns: nominal or adjusted?

A retirement planning tool is only as good as its assumptions and inputs. Share your thoughts or ask questions about the internals of the simulation, built in planner assumptions, or planner inputs.
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FRPJunkie
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Joined: Wed Feb 24, 2016 8:17 am

Returns: nominal or adjusted?

Post by FRPJunkie » Thu Feb 16, 2017 7:26 am

If one enters an inflation rate and standard deviation on the main screen, are the projected returns nominal or are they inflation adjusted? I realize they are in current dollars.

jimr
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Joined: Thu Feb 28, 2008 6:48 pm

Re: Returns: nominal or adjusted?

Post by jimr » Thu Feb 16, 2017 8:39 am

The returns are nominal. So an 8% return with a 3% inflation rate is equivalent to a 6% return with a 1% inflation rate.

FRPJunkie
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Joined: Wed Feb 24, 2016 8:17 am

Re: Returns: nominal or adjusted?

Post by FRPJunkie » Thu Feb 16, 2017 4:56 pm

jimr wrote:The returns are nominal. So an 8% return with a 3% inflation rate is equivalent to a 6% return with a 1% inflation rate.
Jim, if that's the case then what (if anything) is the effect/purpose of entering an inflation rate on the main screen? Are you saying that the rates and returns that are output thus need to be manually adjusted for inflation?

Example:
I set the portfolio investing style as Above Average Risk, which means 62/17/21 (and a side question: is "Intl" stocks or bonds?)

This appears to use an average return of 9.5%, with 14.3 standard deviation.

I set the inflation avg at 1.5%, deviation at 1.0

When the planner is run, the detailed view does indeed show these return numbers. But what about the inflation numbers? Are these used somehow?

If my portfolio shows a value of $2.0 million in 15 years, is this then without an inflation factor?

jimr
Posts: 518
Joined: Thu Feb 28, 2008 6:48 pm

Re: Returns: nominal or adjusted?

Post by jimr » Fri Feb 17, 2017 7:41 am

I think maybe a source of confusion is that the detailed view shows all dollar amounts in present value (2017) dollars.

The inflation rate and the rate of return are very interlinked, but inflation can also have an impact on a retirement plan that's independent of the rate of return. The main example of this is when you have retirement income sources that don't adjust for inflation. For example, if you have a fixed pension payout, or a fixed annuity payout, the purchasing power of that payout will diminish each year as inflation eats away at it.

A good way to see this is to create a pension cash flow in additional inputs that has the COLA set to 'No COLA'. After you run the planner, if you look in the detailed view you'll see the real value of the pension cash flow decreasing each year.

FRPJunkie
Posts: 23
Joined: Wed Feb 24, 2016 8:17 am

Re: Returns: nominal or adjusted?

Post by FRPJunkie » Fri Feb 17, 2017 1:31 pm

jimr wrote:I think maybe a source of confusion is that the detailed view shows all dollar amounts in present value (2017) dollars.

The inflation rate and the rate of return are very interlinked, but inflation can also have an impact on a retirement plan that's independent of the rate of return. The main example of this is when you have retirement income sources that don't adjust for inflation. For example, if you have a fixed pension payout, or a fixed annuity payout, the purchasing power of that payout will diminish each year as inflation eats away at it.

A good way to see this is to create a pension cash flow in additional inputs that has the COLA set to 'No COLA'. After you run the planner, if you look in the detailed view you'll see the real value of the pension cash flow decreasing each year.
Yes, and I have done that since we do have an (expected) pension income that is not COLA'd (or is, but at irregular intervals).

That said, I guess I'm still not understanding how to read what I am seeing in the results. Put simply, does the value one enters for inflation interact with the portfolio return value, and if so have the numbers that are returned taken this interaction into account?

Perhaps part of the difficulty is inherent in the design: since the values returned are in current dollars, how is one to read those numbers with respect to what they really mean for the future in terms of inflationary effects?

Let's say the portfolio has a 2030 value of $2 million, which is what FRP gives in PRESENT dollars. That could be $4 million in 2030 dollars, or it could be $2.5 million, or it could be $1 million with rampant inflation. Right?

jimr
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Joined: Thu Feb 28, 2008 6:48 pm

Re: Returns: nominal or adjusted?

Post by jimr » Fri Feb 17, 2017 1:57 pm

FRPJunkie wrote:Put simply, does the value one enters for inflation interact with the portfolio return value, and if so have the numbers that are returned taken this interaction into account?
They do interact and the numbers fully take this interaction into account. The best way to understand the interaction is to experiment with different values for inflation and return. Set return to custom and set std deviation to zero for both return and inflation.

Next, try setting the inflation rate to a very high value (say 9%) and then setting it to zero to see how it impacts things by looking at the detailed view.
Perhaps part of the difficulty is inherent in the design: since the values returned are in current dollars, how is one to read those numbers with respect to what they really mean for the future in terms of inflationary effects?

Let's say the portfolio has a 2030 value of $2 million, which is what FRP gives in PRESENT dollars. That could be $4 million in 2030 dollars, or it could be $2.5 million, or it could be $1 million with rampant inflation. Right?
The issue is one of anchoring. We're very conditioned to feel comfortable talking about a number of dollars. However, when we're talking about dollars in 20-30 years, this kind of thinking is actually a trap. Telling me how many nominal dollars I'll have in 2030 doesn't actually convey any useful information except perhaps how big of a container I'll need to haul the dollars to the grocery store.

The outputs in FRP focus on purchasing power rather than a valueless number of future dollars. Since we can't intuitively know what a dollar will buy in 2030, telling someone how many 2030 dollars they'll have would just show a hugely inflated number of dollars that doesn't have a meaning.

FRPJunkie
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Re: Returns: nominal or adjusted?

Post by FRPJunkie » Sat Feb 18, 2017 9:55 am

Makes sense, thanks Jim!

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