Planning your financial future has a lot to do with looking ahead and making assumptions. Those assumptions forecast what might happen to your finances in the future and enable you to plan so you can ensure you make the most of your money and achieve your financial objectives. This modelling shows your current position relative to your preferred position and your goals by assessing your current and forecasted wealth.
This detailed picture includes investments, debts, income and expenditures, which are projected forward, year by year using calculated rates of growth, income, inflation, wage increases, and interest rates.
Selecting the correct assumptions are important as small variations in the figures can greatly impact future planning.
The first key assumption is which rate of return you use for the growth of your investments.
The second key assumption is the rate of inflation.
Understanding how inflation works and your rate of inflation is essential. This will help you understand how much you need to return to keep up your future buying power. If you get a 5% increase in portfolio return, but inflation is 7%, you are at a net loss of 2% in terms of real value.
Inflation has been higher in the discretionary goods and services on which wealthier and middle-aged households spend a greater proportion of their income—items such as cars, furniture, hotels, and recreation.
Your own personal inflation rate is something to watch and is a valuable metric. We refer to this as your ‘Personal Inflation Index’. Whilst inflation indexes use standard data for each country, they encompass a lot of price points that you may not buy. On the other hand, your own personal inflation index may include items that have increased substantially that may not be recorded in, or have a more minor component of, the general index.
Looking at your index when it comes to planning is important so you know what required rate of return you need a portfolio of assets to achieve. Your expenses will be different to the general consumer index, such as the CPI (Consumer price index).
If you have children located around the world, the cost of travel, flights, hotels, and the like will have an impact on your assumptions. The current increases in school fees do generally outstrip the inflation index. The cost of private health care also tends to be higher than standard indexes.
Without acknowledging inflation and the real buying power of your income, you may slowly fall behind on your financial goals. But, by building out a solid financial strategy, understanding your current index, and calculating how much money you actually need to pursue your long-term goals, you will be better positioned to achieve your life’s objectives.
Retirement spending also requires your personal index to be accurate—you don't want to run out of money. Your expenses will be funded from your income and assets, you should keep a check on the inflation of the expenses to help make sure your money lasts.
With every financial corner you turn, it is important to run through the numbers, which will help you make the right financial decisions. It is important to be specific. For example, it is not enough to say, “I want to have enough to retire comfortably.” It would be best if you thought realistically about how much you will need—the more specific you are, the easier it will be to come up with a plan to achieve your goals.
Avrio Wealth builds financial plans for our clients and we discuss personal inflation as part of your assumptions.
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