Is it much the same as for workers?
I’ve been reading a lot recently about imperfections in the way in which governments measure inflation, prompted by an announcement that, in the US, next year’s Social Security pension payments will be 1.3% higher than this year’s, reflecting the relevant measure of inflation. In turn, this has generated articles (some outraged) saying that retiree inflation is different from (and higher than) the rate of inflation that the general population experiences. All of which has prompted me to explain this to myself, and I hope you’ll get something out of this explanation.
Inflation is the rate at which prices increase: for example, it may be stated as 2% (or 1%, or whatever), and it’s typically measured over a 12-month period.
Which prices? Ah, that’s actually a subtle and tricky question.
We all spend our money buying different things. And those things can increase in price from time to time. You and I spend our money differently; for example, even if we spend the same amounts in total, I may spend a greater proportion of my budget on food than you, and you may spend a greater proportion on vacations than I do. And if, over the next 12 months, vacations increase in price more than food, you’ll need more money next year than I will; in other words, the inflation you’ll experience will be higher than the inflation I experience. So really, inflation is different for each of us, depending on how we fill our personal basket of goods and services.
Governments design standard contents of baskets, reflecting averages over the whole population, otherwise there’d be no official standard measure of inflation. They actually standardize the contents of several baskets. So, for example, we read about consumer prices and about wholesale prices; and even consumer prices can be subdivided: for example, there’s the partial consumer basket that explicitly excludes food and energy. Then there’s the personal consumption basket. Isn’t that the same as the consumer basket? Not quite: it assumes that the proportions bought are the same as the proportions produced in the economy, rather than the proportions actually bought by consumers. And never mind the retail price index, which is yet another variant! And many countries have many variants. But you get the idea.
Relatively small differences, really, in the big scheme of things, and economists debate which index (or which basket) is more appropriate for a particular application. But as you can guess, most of the time differences of this sort are small.
There are much bigger differences that involve the use of things that extend over several years. For example, how does an index take car ownership into account? No matter what the answer is, it’s inevitable that those who own cars and those who take public transportation will experience personal inflation that differs from that of the index. Even more so, those who own a home and those who rent will experience inflation that’s different from each other and from the index.
Because spending patterns change, from time to time the official composition of the baskets changes. There’s no way you’ll keep track of it all.
The reason that these official measures of average baskets are important is that governments often use them to increase pensions every year.
What all of this also means is that any such official increase in your pension is intended to be very roughly, but certainly not exactly, in line with how your personal basket’s prices have changed. Why not exactly? Because, you’ll remember, we all have different things in our personal shopping baskets!
It turns out that, on average, workers and retirees buy different baskets of goods and services. On average, retirees spend a greater proportion than workers on shelter (housing) and maintaining the home, and on health and personal care. Workers spend a greater proportion than retirees on transportation, and on clothing and footwear. (No surprises there, really.) When cost indexes are built to reflect these different proportions, the corresponding measures of inflation are naturally different.
By how much? It varies from country to country (among the few countries where these studies have been conducted), and studies suggest that retiree inflation may be slightly higher than worker inflation, but I haven’t seen anything suggesting a difference that exceeds 25 cents a year for each $100 of spending, on average.
For example, I recall Stephen Goss, the Chief Actuary of the Social Security Administration (SSA), and someone I have met and admire enormously, reporting on a comprehensive study conducted at SSA, to the effect that (subject to all the inevitable index-construction difficulties I’ve mentioned) a hypothetical inflation index reflecting the spending of the elderly over the previous 10 years would have increased by 0.2% (20 cents per $100) a year faster than the index used for Social Security’s COLA (Cost of Living Adjustments).
So, my big personal conclusion is that I ignore any difference and live with it. Most of my spending choices (let alone my financial issues) involve much more than 25 cents per $100 of spending. And, what’s more, there’s nothing you or I can do about it. You can’t find a selection of investable assets, for example, whose prices change to align exactly with different measures of inflation, so that you can select the measure and the assets that best fit your personal spending basket. So this is all out of your control.
The only thing that is genuinely within your control is the extent to which your financial planning takes the likelihood of future inflation into account. This is something you should definitely do – but that’s beyond the scope of this blog post.
One final word. Your own spending patterns are likely to change over time. Most of us start in what’s colloquially called the “go-go” early stage of retirement, when we finally get to do things we’ve been wanting to do for years, and then typically we gradually transition to the “slow-go” stage, when we downsize our lives a bit. So our personal baskets of goods and services change over time. Another reason not to worry about different measures of inflation.
Inflation is much the same for all – possibly slightly higher for retirees than for workers, but there’s nothing you can do about it and it’s not worth worrying about.
I have written about retirement planning before and some of that material also relates to topics or issues that are being discussed here. Where relevant I draw on material from three sources: The Retirement Plan Solution (co-authored with Bob Collie and Matt Smith, published by John Wiley & Sons, Inc., 2009), my foreword to Someday Rich (by Timothy Noonan and Matt Smith, also published by Wiley, 2012), and my occasional column The Art of Investment in the FT Money supplement of The Financial Times, published in the UK. I am grateful to the other authors and to The Financial Times for permission to use the material here.