IN FINANCIAL PLANNING, AS IN LIFE, RELATIONSHIPS ARE EVERYTHING

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When building financial plans for clients (you know if you’ve seen one: lots of pretty graphs and so forth) I have to assume what future inflation rate to use. Many key assumptions go into a plan, and the inflation one is first among equals. It’s the variable that can have the most impact, as it’s going to be in the client’s (your) plan from now until the moment you die.

Other things in a plan will vanish over time (wages, investment pots etc) as they reach a natural conclusion or are spent down. Any assumptions linked to these assets (eg future investment returns, wage increases etc) likewise disappear. But inflation, like gout, will ebb and flow and is there until you’re not.

Since 2008 I’ve used an assumed future inflation rate of 4% a year as my go-to figure in doing this planning work. Most of that time 4% has been above actually experienced inflation and certainly ahead of the Bank of England’s target of 2.5% (stop sniggering at the back). Currently, of course, inflation is way over 4% a year. If it gets “baked into the system” at present levels then perhaps I will revisit my inflation assumptions.

But let’s give that particular cake a bit more time in the baking: for now, I’m sticking with 4%. And I’m comfortable doing that.

Why, I hear no one ask.

In financial planning, it’s the relationship between the numbers that matters, rather than the numbers themselves. Our assumed growth rate on invested assets (eg The Great Companies of The World (GCOTW) held in your pension and ISA pots etc) is 3% over inflation, at 7% a year. This seems reasonable. It’s not guaranteed and never can be. Cash returns are estimated at 2% a year, or half the inflation rate. Again, feels about right. Again, is not guaranteed and never will be.

So annual assumptions used in financial plans (yours and mine included) are

1. 4% inflation (RPI)
2. 7% Great Companies of The World (GCOTW)
3. 2% cash savings

Quick aside: somewhere a compliance person who has passed every known financial services exam and is simply dripping with accreditations is shrieking into the void about this. I don’t care. I never did care.

What have been the actual annual returns over the last decade??Source: Dimensional Fund Advisors ten years to end October 2023. Cash figures based on Moneyfacts 90 Days Notice

1. 4.1% inflation (RPI)
2. 8.4% GCOTW (our default world equity fund net of management fees, gross of advice/platform fees)
3. 1% cash savings That was the very best rate I could find. I haven’t cherry-picked it.

So the assumptions are amazingly close to the actual lived experience (stupid phrase: what the hell is “unlived experience”?)

Back to the relationship thing: should inflation bake in at, say, 8% then we would increase the expected return on The Great Companies of The World (GCOTW) to, perhaps, 10-11% per annum. Company share prices are driven largely by nominal company earnings (profits). In times of high inflation, companies raise their prices and increase their profits. That’s a very quick and dumbed-down explanation for what drives share prices and it’s at the very outer limit of my comprehension; already I feel a migraine coming on.

With a level of God-given prescience that is staggering even for a genius like me, I talked about a likely bout of future higher inflation at a conference in 2021 . Called “Inflation Nation: 1962-1991” it was a typically majestic and bravura piece of work, informing the enthralled delegates (paying delegates, at that, mad loons) that in those three high-inflation decades, the Great Companies of the UK (The FTSE-AllShare) returned 14.1% per annum including dividends, whilst inflation ravaged along at a terrifying 8.1%.

The relationship between the numbers here? If you invested in UK plc through those 30 years, you effortlessly picked up an inflation-adjusted real return of 6% a year. That’s not just warding off inflation. That’s kicking it into the outer realms of space, where nothing ever happens. Think Joe Biden’s cerebellum and you get the idea.

To conclude: we don’t like awake at night thinking about inflation assumptions. We understand that it’s the relationship between the numbers that matters and that, even in periods of high inflation, owning a beautifully diversified portfolio of around 13,000 of The Great Companies of The World (GCOTW), via our preferred global equity fund, is probably your best defence.

IN LIFE, RELATIONSHIPS AREN’T ALWAYS CONSTANT. BUT IN FINANCIAL PLANNING, THEY SHOULD BE. MAKE SURE YOUR PLANNER KNOWS HER ONIONS ON THIS. IT MATTERS.