Stress Testing Financial Plans for Inflation

Stress Testing Financial Plans for Inflation

While many financial advisors discuss the corrosive impact inflation has on purchasing power in retirement with their clients, the truth is that the past few decades of low inflation have made this caution sound a bit hyperbolic.

After years of monetary accommodation—and amid supply bottlenecks that may continue for years and outsized fiscal spending—inflation may become a more persistent feature of a future economic landscape than the transitory phenomenon the Federal Reserve (the Fed) continues to maintain it will be.

Inflation is arguably the most important assumption in an individual’s financial plan. A 2% inflation assumption may produce a satisfactory retirement projection, while a 5% assumption results in running out of money too soon.

Stress Testing Financial Plans

Most clients and many advisors do not know what level of inflation will turn a solid financial plan into a shaky one. Clients operating on an old financial plan or using an assumption that expects the next 10-20 years to be like the last 10-20 years may need to find out if their retirement plan can survive an alternate future that includes higher, sustained inflation.

Of course, some income sources are indexed to inflation, like Social Security and an employer’s pension; however, for most working and recently-retired Americans who are relying on their savings, it is a one-way road that leads to either higher-than-anticipated retirement withdrawals or a lower standard of living.

It’s not only the financial plan that advisors and clients must revisit. Their investment strategy also may need to change to adapt to an entirely new economic and investment landscape.

Think of it as the climate change of the investment environment. Like climate change, everyone will need to think differently as new dangers and opportunities present themselves. A client’s allocation, for instance, will need more inflation-protected assets, like equities. Even among a revamped equity exposure, the components of that equity allocation will need to be different than it may have been in a low inflation world.

A bond allocation may not disappear, but a fixed-income portfolio needs to be cognizant of what inflation does to the value of long-term bonds over an extended period of time.

It’s difficult to say where inflation may go from here, but it may be wise to begin assessing what it means for your clients’ financial plans and investment strategies.

 

Please reference disclosures: https://blog.americanportfolios.com/disclosures/

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