How inflation data are compiled usually interests only economists and statisticians, and only a few of them at that. Yet, retirees and those planning for retirement have more than a passing interest in the debate.
The reported inflation rate determines increases in Social Security benefits and adjustments to Treasury Inflation-Protected Securities (TIPS). It also determines increases in the few pensions indexed for inflation.
Most importantly, the reported CPI also influences your retirement plans. You (and your financial planner if you have one) use the CPI to estimate inflation over your retirement. The results influence estimates of your retirement spending and the amount of income you’ll need. The CPI also may influence the amount you decide to withdraw from your investment accounts each year. (See the article on page 6.)
For these reasons, you should know a bit about how the CPI is determined and how accurate it may be.
The government made changes to the CPI computation over the years, and some economists and analysts believe these changes make the CPI understate the inflation consumers face. Some of the changes were major, systemic adjustments to the formula or methodology for the long-term. Specifically in 1999 the government made adjustments for product quality improvements and consumer substitution. These changes assume consumers receive the same or higher quality goods and services because of improvements or substitution. Prices might be revised downward to reflect the higher quality of some goods. While complicated, these changes make the CPI lower than it would be.
There also are some complaints about the use of rental equivalent income instead of actual home prices in computing housing inflation. The government says actual home prices are too volatile and are partly investments instead of spending. It believes a more accurate measure of housing inflation is the cost of renting.
Other changes are temporary. For example, during the cash-for-clunkers program the auto component of CPI was calculated using retail prices instead of the net prices consumers paid after the government subsidies.
The most vocal critic of CPI probably is John Williams. He runs the Shadow Government Statistics web site at www.shadowstats.com, where you can find alternative data for CPI and other government data. Williams estimates the real CPI since 1987 is much different from the reported CPI. He thinks inflation in 2009 was over 5%, not the reported negative value.
You can’t do anything about how the CPI affects Social Security benefits, TIPS adjustments, and other factors. But you can ensure your plans use more accurate inflation numbers.
We always have recommended against using a generic or overall inflation rate in your planning. Each person has his own spending pattern and therefore his own inflation rate, because each good or service has a different inflation rate. We even make available a Retirement Spending spreadsheet on our web site (under “Extras”) subscribers can download free. This spreadsheet allows you to set a separate inflation rate for each item in your budget and develop a more accurate overall inflation rate.
Above all, review your plan and be flexible. There’s no need to adjust your long-term spending plan for short-term changes in inflation. But when inflation is higher or lower than your forecast a few years in a row, you need to adjust your plan, spending, and perhaps your investments.
February 2010 RW