Your "Help" manual doesn't speak to "Inflation" on the "economic variables" page of the "assumptions" section. (I've tried different inflation scenarios and the results (living standard increases as does inflation) seem counterintuitive.)
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Alan:
If you change inflation from the default 3% up to, say, 5%, you should see the living standard go down. Make sure that you click "apply" at the bottom of that panel after you change the inflation number.
Is that not what you see happening?
Dan
Thanks, Dan, but it's not working in a manner consistent with what you suggest.
At 5% inflation the program is recommending annual consumption of $122,382 ($76,489 per adult).
At 3% inflation the program is recommending annual consumption of $121,570 ($75,981 per adult).
(I'm using version 2.11.3C.)
Any other thoughts?
Thanks,
Alan
I spoke with Kotlikoff about this.
He says that for some people inflation hurts their consumption, but for others it can help their consumption. When it helps, as it does you, typically it's related to the mortgage that is being paid down with cheaper dollars. Apparently there are other things that can play into this, but that's common I guess.
So perhaps you have a significant mortgage payment that is benefiting from this higher inflation?
Does that make sense?
Dan
Thanks again for your prompt reply, Dan.
But the plot thickens, as there's no mortgage at all!
Alan
P.S.: Do you think someone should take a look at my data file?
Ha!
Well, sure.
Go to the main website and see "My ESPlanner" and use the "upload" to upload your database. I'll have Kotlikoff take a look and either he or I will get back with you.
Dan
I sent you a sep email. Try the upload again.
There are other reasons that inflation can sometimes help living standard. Kotlikoff said he'd take a look.
Dan
Hi Dan. I didn't receive your separate email.
I did upload the file again (the correct one this time!).
Thanks,
Alan
Alan,
I've seen the upload but am on vacation so my response time is slower than usual. It will be gotten to but...I'm on vacation.
Best,
Dick Munroe
Dick --- Please enjoy your vacation! The matter is not urgent at all. (Though I suspect you'll be interested in it because it just might be pointing to a bug in the program.)
Thanks much,
Alan
Yes, Kotlikoff is taking a look at it tonight.
We'll be back in touch.
Dan
I also found some strange results when altering inflation (but keeping the real return on any investments at 3% by bumping up the nominal return). The textbook explanations of the 'costs of inflation' suggest:
1. it helps borrowers (e.g. fixed rate mortgage holders)
2. it hurts investors (typically the nominal return is taxed and inflation bloats these values)
3. it helps those who work into their 60's (SS benefits are based on the 'best 35 years'; pre-60 are adjusted for nominal wage growth; post-60 are entered as their nominal values). Assuming your wages go up with inflation you may get six big numbers to average into SS benefit calculations -- assuming you work thru age 66).
4. it may hurt those who are eligible for certain non-indexed tax credits (e.g. the 1000 child credit). I think ESP indexes many of these over time even if they are not indexed to inflation.
5. it may hurt low- to middle-income retirees who SS benefits are only partially taxable (above long-fixed thresholds 85% of benefits become taxable income).
6. it will hurt those with DB pensions where the benefits are only partially indexed to inflation
7. it should be neutral wrt earnings as these are entered in real terms and any inflation is assumed to be in addition to 'real raises'
8. Volatile, high inflation can also cause 'uncertainty in the markets' and in financial planning but this 'psych cost' is not part of financial planning models.
Any way, back to my hypothetical story. I setup a very simple scenario (single, real income 30K/yr, all savings outside of retirement accounts, no medicare, no bequest, no home). Basically a guy living in a van down by the river.
When I change inflation from 0 to 3 to 10% (nominal returns of 3%, 6.09, 13.3%, respectively -- keeping the real return at 3%) I see huge swings in the annual consumption and SS benefits. Annual C ranges from 26,819 to 23,832 to 20,626. Even more bizarrely I get SS benefits of 44K, 18K, 4K! Why would 0% inflation lead to a SS benefit > than the avg. income of 30K? The middle case seems to make sense (a modest income individual would get 60% of their avg earnings). The 10% inflation case kills SS -- I thought it would help (see #3 above).
Has anyone else tried differing inflation rates and noticed similar outcomes? Please let me know your experience.
pvh
I can probably figure out a reason but once again, I'm on vacation so it will take a while for me to have some time to goof with this.
Best,
Dick Munroe