Issue: 315
Sent: 05-09-2012 15:08:02
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Advisers Risk Underestimating Long Term InflationYes can be the hardest word part 6ATO's controversial tax ruling on pensions seems to have stalled
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Advisers Risk Underestimating Long Term Inflation

Click here to buy - A How To Book of SMSF's by Tony Negline
John Robertson

Financial planners risk being misled by using the macroeconomic inflation target as the basis for planning their clients' financial needs.

The June quarter consumer price index was 1.2% higher than in the previous corresponding period and, consequently, below the expressed policy target of having inflation within a 2-3% band over the course of an economic cycle.

Even taking out the volatile food and energy categories from the CPI threw up a 1.7% rate of inflation over the prior 12 months.

There is now a relatively long history of Australia's inflation performance being in line with the inflation targets set in the aftermath of the 1980s when the rate of price increase was rocketing out of control.

Since 2000, the average annual rate of increase in the consumer price index has been 2.8%.

An inflation rate of 3% and an output growth rate of 3.5% would suggest long term profit growth of 6.5%.The inflation outcome is one of the guideposts, along with economic growth, for the profit potential within the Australian economy and, consequently, prospective equity investment returns.

From that perspective, the generalised rate of price increase is a valid consideration for financial planning purposes.

Inflation is also the rate at which income must grow to be able to sustain spending power. It is too simplistic, however, to assume that the targeted macroeconomic rate is going to be the same as the rate at which the value of household budgets are being eroded.

Within the overall consumer price index, the household spending items showing the largest price increases have tended to come from utilities, education, child care, health charges and insurance.

Over the last 10 years, utility charges have been rising at a rate of about 7%. Since 2008, child care has been rising at a similar rate. Education charges and medical and hospital costs have been going up at a 6% pace for 10 years.

These items are among the least discretionary in the household budget. Even where some choice can be exercised, a purchasing decision tends to lock consumers in for the long haul. A choice of school, for example, can be a 12 year commitment. Moving students in response to higher prices is a tough call for a parent.

Marginal changes to the quantity of electricity or water used may be possible but eliminating them from the budget for any amount of time is impossible.

In contrast, consumers can respond to a large increase in the price of bananas, or any other foodstuff, by cutting back or eliminating their consumption. Spending can gravitate to cheaper fruits and vegetables or cheaper cuts of meat or other foodstuffs.

Similarly, consumers can adjust to changes in the prices of clothing or other goods. They can pick between buying on-line or at a traditional bricks and mortar store to better manage the spending power of their incomes.

This distinction between discretionary and non-discretionary budget items is more than academic since there is such a clear difference between the inflation rates among the two product groups. Moreover, the higher inflation rates among the non discretionary items are part of a long term trend that does not appear to be slackening.

If anything, the rate of increase in energy prices seems set to steepen. With pressure to improve the quality of school teachers, education charges are similarly facing upward pressure. Ditto childcare and medical charges.

The only foreseeable way in which these price pressures could be abated is through government intervention. These are areas in which governments remain highly active, as we have seen in recent days with initiatives in dental care, disabilities and education at the national government level.

However, initiatives such as these create an additional tax burden so that, one way or another, the household budget pressures could prove daunting.

The differences are substantial. A household currently spending $40,000 a year on non discretionary items, including private school fees, would see that figure grow to $58,000 a year after 15 years if the rate of increase was in line with the policy objective of inflation sitting between 2% and 3%.

However, if the rate of increase was 7%, that household would have to find an additional $340,000 to cover the costs of these goods and services. This is not a trivial amount.

Realistic financial planning would suggest that a 2-3% inflation rate should be used for purposes of forecasting investment returns. However, a higher rate of inflation should be used to measure the increase in household spending requirements to take account of the growing impact of non discretionary items on household budgets.

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