Following on from our “Life begins at 60” article on life expectancy, I thought it would be useful to explain the inflation assumption we use in our Financial Plans.
This has a significant impact on cash flow projections (the bucket) so it is important that it is as close to accurate as possible.
The December CPI figure announced in January indicates that UK CPI inflation fell to 2.1% in December 2018, its lowest level in two years and that at least for this month, CPI is now within touching distance of the Bank of England’s 2% target.
At Henwood Court, our current standard assumption is to use an inflation figure of 2.5% which is based on analysis of historic CPIH figures. CPIH for December 2018 was 2.0%, slightly lower than CPI.
The Consumer Prices Index including owner occupiers’ housing costs (CPIH) is the most comprehensive measure of inflation; it extends the Consumer Prices Index (CPI) to include a measure of the costs associated with owning, maintaining and living in one’s own home, known as owner occupiers’ housing costs (OOH), along with Council Tax. Both of these are significant expenses for many households and are not included in the CPI.
While no-one is “average”, it is still convenient to have summary price measures which, although they may not strictly apply to any one individual or family, will still give us a useful yardstick of the impact of inflation on our own pocket or purse.
Considerable care is taken to ensure that the CPI shopping basket is kept up-to-date and is representative of people’s spending patterns: the places and shops we go to, the goods and services that we buy and the amounts we spend on them.
Historically RPI has been an inflation measure used; compared with the CPIH and CPI, the RPI has a much longer history. The series started in 1947, and prices are expressed relative to January 1987, when the index has a value of 100. The official series for CPI started in January 1996, although estimates are available back to 1988, the official series for CPIH starts in 2005.
CPIH and CPI however covers a broader population than the RPI. The RPI includes certain items relating to housing costs (such as mortgage interest payments and also a measure of housing depreciation) that are not included in the CPIH and CPI. Conversely there are also some services covered by the CPIH and CPI – such as charges for financial services – which are not in the RPI.
Whilst use of RPI as a measure is becoming less popular the Office of National Statistics (ONS) has acknowledged that “there is significant value to users in maintaining the continuity of the existing RPI’s long time series without major change, so that it may continue to be used for long-term indexation and for index-linked gilts and bonds in accordance with user expectations”. Some users clearly value the continuity of the index, despite its flaws.
Ongoing work by the ONS and others has strengthened the case against the RPI, and the evidence suggests it is likely to overstate inflation. We have also been receiving feedback from some clients that they consider RPI is an outdated measure of inflation, hence we carried out detailed analysis and revised our assumption.
Since the majority of our clients do not have mortgages, we concluded that CPIH is the most suitable inflationary figure to be used as a default assumption within financial plans.
Analysis of CPIH concludes that the average over the period from August 2006, when CPIH was rebased, to February 2018 was 2.3%. Therefore, to make our forecasts conservative an inflation (CPIH) assumption of 2.5% is currently being used.
Our standard assumptions are reviewed on an annual basis and are discussed and agreed with our clients at their Annual Financial Planning meetings but if you have any queries, please do not hesitate to contact your Financial Planner at Henwood Court.