Inflation Adjustment Question

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Old Mike
Posts: 12
Joined: Wed Aug 19, 2020 2:52 pm

Inflation Adjustment Question

Post by Old Mike »

I devoted time each night this week to reading FRP's FAQ pages but there is one topic that still confuses me in regard to the inflation options on the Additional Inputs tab.

Does the inflation adjustment begin right away if the start year of the expense cash flow type is not immediate?

For example, say I have a vacation planned for 2025 that will cost $10,000 in today's dollars. It is safe to assume that FRP is factoring the cost of the vacation into my plan with 5 years of inflation on the $10k?
jimr
Posts: 725
Joined: Thu Feb 28, 2008 6:48 pm

Re: Inflation Adjustment Question

Post by jimr »

Yes. Assuming you choose the "track inflation" option when you create the cash flow in Additional Inputs the amount you enter will be annually adjusted for inflation, both before it begins as well as after it starts.

In general, you can verify how the planner is handling a cash flow by looking at the year-by-year expense amount in the detailed view tab.

All dollar values in this view are shown in present value dollars. That means if a nominal amount is exactly keeping up with inflation, the dollar amount shown in the table will remain constant from year to year. If a nominal amount is growing at a rate greater than the inflation rate, the dollar value shown in the detailed view table will increase from year-to-year. Finally, if the nominal amount is growing, but at a rate less than the inflation rate, the dollar value shown in the year-to-year table will be decreasing.
Fortitude
Posts: 10
Joined: Sun Mar 28, 2021 8:53 pm

Re: Inflation Adjustment Question

Post by Fortitude »

jimr wrote: Fri Aug 21, 2020 8:13 pm Yes. Assuming you choose the "track inflation" option when you create the cash flow in Additional Inputs the amount you enter will be annually adjusted for inflation, both before it begins as well as after it starts.
After I read this, I realize that I need to make some adjustments to how I'm treating expenses that I expect to begin in the future. I'm not sure if FRP has the capability to achieve what I'm trying to do. If it does, perhaps you can guide me. Here's the scenario.

Suppose I have medical expenses that I don't expect to incur until five years from the start of the plan. Once they begin in year 5, I expect them to grow at an annual inflation rate of 10%. I create an Additional Input for this expense and enter the amount in today's dollars and I enter a COLA Percent of 10%. However, not onIy do I want this expense to increase annually by 10% beginning in year 5 of the plan, I need FRP to inflate the expense by 10% from the start of the plan through year 4 so the dollar amount of the expense has been properly inflated by the time I actually begin incurring the expense in year 5. My understanding is the way to achieve this is to enter a 10% Inflation Average on the main screen and set the COLA Type for the expense as Track Then Fixed. Is this correct?

If so, the problem that I believe this creates is in regards to the other Addition Inputs that I've created for other expense categories that occur at different future points in the plan. Although I can create different inflation rates for these expenses once I begin to incur them, it appears that I can't apply different inflation rates to these other expenses prior to when they begin since there is only one field on the main screen to enter a Inflation Average. In my example, all expenses would be inflated at 10% before they occurred.

Am I missing anything? Is there a way to apply different inflation rates to each Additional Input before the expense actually begins and if so, how would I do that?
jimr
Posts: 725
Joined: Thu Feb 28, 2008 6:48 pm

Re: Inflation Adjustment Question

Post by jimr »

If I understand you correctly, I think you can just use Fixed COLA at 10%. That results in the expense getting inflated at 10% starting in the first year of the plan and every year after that, regardless of when the actual start year of the expense.

You can try it out and check the detailed view to make sure it's doing what you expect. For testing, it might be easiest if you set inflation to 0% and the spending policy to stable. Then change inflation to some other rate and make sure the expense grows at the rate you expect. In the detailed view, if inflation is 3% and the Fixed COLA rate is 10%, you should see the expense grow by 7% (real) each year, starting from the beginning of the plan, regardless of when the cash flow starts.
Fortitude
Posts: 10
Joined: Sun Mar 28, 2021 8:53 pm

Re: Inflation Adjustment Question

Post by Fortitude »

jimr wrote: Fri Apr 02, 2021 12:13 pm If I understand you correctly, I think you can just use Fixed COLA at 10%. That results in the expense getting inflated at 10% starting in the first year of the plan and every year after that, regardless of when the actual start year of the expense.
You understood me perfectly and you confirmed for me that I had it right the first time with Inflation set to zero on the Summary page and the COLA Types set to Fixed COLA.

I questioned myself because Planned Expenses looked quite a bit high in the outer years of the plan. So I enabled a single expense and ran reports one by one for one for the expenses I chose that have varying inflation rates to see what was calculated for each expense on their respective reports. As you stated, it applied the inflation rate in the first year of the plan and every year after that, regardless of the actual start year of the expense.

Thanks for your help!
jimr
Posts: 725
Joined: Thu Feb 28, 2008 6:48 pm

Re: Inflation Adjustment Question

Post by jimr »

Fortitude wrote: Fri Apr 02, 2021 2:21 pmYou understood me perfectly and you confirmed for me that I had it right the first time with Inflation set to zero on the Summary page and the COLA Types set to Fixed COLA.
The only caveat I'd add is that I when suggested setting inflation to 0% on the main page, that was only for testing purposes, not for your normal runs.

In general, most people wouldn't want to use a 0% inflation rate for that main input.

One key reason for this is that the default returns on that main input page are nominal returns and assume that there will be inflation eating away part of their value. Inflation doesn't just impact income and expenses, it also eats away at the portfolio value.

For example, with the moderate portfolio, the return defaults to 8% nominal return. However, by default inflation is 3% So this translates into about a 5% real return. If you zero out inflation but leave the return at 8%, that'd be saying you expect an 8% real portfolio return instead of a 5% return. So you'd be artificially boosting the portfolio return quite a bit.

Does that make sense?
Fortitude
Posts: 10
Joined: Sun Mar 28, 2021 8:53 pm

Re: Inflation Adjustment Question

Post by Fortitude »

jimr wrote: Fri Apr 02, 2021 3:26 pm
Fortitude wrote: Fri Apr 02, 2021 2:21 pmYou understood me perfectly and you confirmed for me that I had it right the first time with Inflation set to zero on the Summary page and the COLA Types set to Fixed COLA.
The only caveat I'd add is that I when suggested setting inflation to 0% on the main page, that was only for testing purposes, not for your normal runs.

In general, most people wouldn't want to use a 0% inflation rate for that main input.

One key reason for this is that the default returns on that main input page are nominal returns and assume that there will be inflation eating away part of their value. Inflation doesn't just impact income and expenses, it also eats away at the portfolio value.

For example, with the moderate portfolio, the return defaults to 8% nominal return. However, by default inflation is 3% So this translates into about a 5% real return. If you zero out inflation but leave the return at 8%, that'd be saying you expect an 8% real portfolio return instead of a 5% return. So you'd be artificially boosting the portfolio return quite a bit.

Does that make sense?
Makes perfect sense and I agree with you that most people would likely use most/all of the fields on the main input screen to generate their plan. I've always wondered how many Additional Inputs people enter to add detail and specificity. I suspect that there's probably a correlation between the number of Additional Inputs and the level of one's financial acumen and the desire for granularity.

Being a recently retired financial analyst/accountant/advisor, this tool is nirvana for someone like me where I can get as detailed beyond what I suspect to be most individuals' desire or patience. I've found this personality characteristic of mine to be both a strength and a curse.

With that said, the frp file that I've developed is highly customized where I have an Additional Input for the return for each portion of the overall portfolio. That means I have separate returns and standard deviations for the tax deferred, tax free and taxable portions of the portfolio as well as separate inputs for these returns for each stage (range of years) within the plan. The Taxable portion of the portfolio has a specific Investment Tax Rate with separate inputs at different investment tax rates during different stages of the plan. These effective tax rates are entered based on what the expected yield and capital gains will be throughout the plan while also taking into account my total projected taxable income and how much of the dividends are qualified and how much of the capital gains are actually taxable based on the projected taxable income throughout the plan.

When it comes to income tax rates, these are also entered as separate inputs and are based on different stages of the plan regarding the level of Roth conversions, miscellaneous income, social security and RMDs that occur throughout the plan and their effect on overall taxable income to determine the effective tax rate.

Inflation is treated the same way. I have separate inflation inputs for different categories of expenses. When I started this plan years ago, I began with much fewer expense categories than I have now. As time has passed, I've added more categories for granularity. For the most part, each expense category has the same inflation rate with the exception of medical expenses. By doing this, not only can I easily change the amount for any expense category based on changes in actual current spending levels, but I can also easily change the rate of inflation for each one as well if necessary.

With the way I'm using FRP, my understanding has always been that I can bypass the fields on the main screen; of course with the exception of the portfolio values, current and retirement ages and life expectancy. The results that FRP has generated have always been reasonable based on my testing.

After reading this, if you believe I'm using the tool in any way that might be generating results that are misleading, please let me know.

Thanks!
jimr
Posts: 725
Joined: Thu Feb 28, 2008 6:48 pm

Re: Inflation Adjustment Question

Post by jimr »

The thing I don't understand for sure is if your setup has inflation hitting your overall portfolio balance. I get that you're inflating expenses in additional inputs, but inflation also diminishes the real value of the portfolio each year as well and I can't tell for sure if you've covered this in additional inputs.

The simulation has an internal inflation rate that it uses each year to "ding" the portfolio value for inflation. If you set the inflation rate to zero on the main page and you don't have any inflation rate entries in the upper table of additional inputs, the simulation will be using a zero percent inflation rate and this means the portfolio won't get hit by inflation each year.

This could be ok if all the portfolio returns that you use are real returns rather than nominal returns. But even this gets complicated because taxes are usually paid on the nominal return (eg 8%) while the actual real growth rate of the portfolio will only be 5%. So if you use a zero inflation rate and a real return rate (say 5% instead of 8%), you'll end up underestimating investment taxes.

If you have inflation entries in the upper table in additional inputs (say with different rates for different periods), then leaving the main inflation input at zero would be fine.
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