Consumer Price Index: The Big Retirement Planning Mistake You Want to Avoid

CPI: The Big Retirement Planning Mistake You Want to Avoid

Your retirement plan should assume inflation will be higher than the published numbers, whether you already are retired or still looking forward to it.

The most widely-cited measure of inflation is the Consumer Price Index (CPI) for all urban consumers. This measure generally has been declining since it peaked in the early 1980s. In recent years, with the exception of a few months it has been below the Federal Reserve’s announced goal of at least a 2% annual rate. Longer-term it’s averaged about 3%.

But the published CPI shouldn’t be the basis of your retirement plans.

To generate the CPI, the Department of Labor’s Bureau of Labor Standards (BLS) takes a list of goods and services that it believes represent the shopping basket of a typical urban or suburban American family. It checks the prices of those items around the country each month. The price changes determine the month’s CPI.

One problem with using the CPI as your inflation benchmark is that the weighting of the goods and services isn’t likely to be the same as your personal purchases. Households composed primarily of people ages 50 and over usually buy a different mix of goods and services than younger households.

For example, an older household is likely to spend more on medical care and less on education. In fact, older households have enough differences from the standard basket of goods and services that the BLS maintains a separate index, the CPI-E (for elderly), to track price changes for older households. This is published only periodically, because the BLS considers it experimental. The CPI-E shows inflation for households headed by those ages 62 and older is a couple of tenths of a percent higher than the CPI-Urban in most years.

There are a couple of other reasons you shouldn’t use any of the published CPIs to estimate your retirement inflation.

One reason is that your mix of spending is likely to be different than any standard basket. Each spending item has a different inflation rate, so any two households are likely to have different inflation rates because of the different mix of goods and services.

Another reason not to use a published CPI in your planning is that the Labor Department has made more and more use of a technique known as the hedonic quality adjustment, or hedonic adjustment.

In the adjustment, the government looks at more than a simple change in the prices charged for a good or service. It also adjusts that price change for changes in quality or features. The result is you might have to pay a lot more for an item than you used to, but because the newer item is higher quality the CPI says the price didn’t change much or declined.

An example on the Labor Department web site compares televisions over time. The price to a consumer has increased by 400%, and a version similar to the original no longer is available. Because of the much higher quality of the current television, however, the CPI says the price declined by 7.1%.

More and more items in the CPI receive a hedonic adjustment. The BLS web site lists 21 categories of items receiving hedonic adjustments. It also says there are other items that receive adjustments but aren’t on the list. You might be surprised that different types of clothing and apparel comprise more than half of the categories that receive the adjustments.

Even some services, such as internet service, receive hedonic adjustments.

As a retiree, you might like the improved quality of an item. But the amount of cash you pay for the item matters greatly to your spending plan.

Don’t rely on recently published CPI numbers when developing future retirement and spending plans. You should assume your inflation rate will be higher and put more of a cushion in your plans. You can safely assume that almost everything you buy will increase in price over the years, and that for you the overall increase is likely to be higher than the CPI says.

Source: Forbes
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