FINANCIAL PLANNING AND INFLATION
Inflation is a big part of financial planning, since it is one of the biggest reasons why people do not achieve their long-term goals. Inflation is the general increase in costs to buy goods over time. In the UK this is measured by the Retail Prices Index (RPI) and the Consumer Prices Index (CPI). You will not doubt have heard that inflation has increased recently, and will probably be feeling this at the petrol pump.
Retail Prices Index
RPI measures the general increase in costs based on an arbitrary basket of goods. This can be misleading because your spending patterns might not mirror the basket of goods. For example, this would include food stuffs and mortgage costs, which might affect you. However, if you have paid your mortgage then this is not so relevant; with mortgage costs low, the RPI does not truly reflect inflation for some groups such as pensioners. Also, the RPI looks at consumer goods; but how often do you buy that TV?
Consumer Prices Index
This is the Government’s preferred measure, partly because it tends to come out lower than RPI, and partly because it reflects standards across the EU, which makes it a measure easier to compare with other countries. CPI does not include mortgage costs, which can also make it less relevant for you if you do have a mortgage.
Why is inflation relevant to financial planning?
If we ignore inflation, we ignore the increase in costs for goods over time. This can lead to wide anomalies in our financial planning because our assumptions will be based on a false premise. Therefore, you should assumne that prices will rise at a realistic rate over time, and aim to compensate for this in your financial plan. For example, if you work out that to achieve your goals you need to save £500 per month based on today’s costs. That’s fine, but in years to come the goal will be more expensive due to inflation. therefore, you probably need to save more towards your goal now, or adjust your savings over time to take into account the increase in costs for goods.
All this is part of a set of standards that we follow when financial planning for clients. There are many other resources on this blog, so check out other sections to see how we do this.
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