Much is being made of how low inflation is at the moment. It is a concern for governments and central banks as it could impact the economy and monetary policy. Individuals, on the other hand, may welcome low inflation, but we should not become complacent about this threat to our wealth.
In the UK, the headlines have been on falling inflation. The Consumer Price Index (CPI) fell to 0% in February, the lowest rate since estimates of the measure began in 1988, and there are concerns about deflation.
We already have deflation in the Eurozone. Although the Harmonised Index of Consumer Prices for the EU as a whole has so far remained above 0% (0.3% in February, the latest statistics available), some countries have fallen into deflationary territory – it was -0.2% here in Portugal.
Does this mean we do not need to worry about inflation anymore? Not at all. In fact, my concern is that some people may stop considering it a threat and fail to plan to protect their savings and income from it.
It is not just inflation today that matters to retirees. It is inflation each and every year over your retirement years that does the damage and can affect your long-term financial security, or how much wealth you pass down to your family.
Inflation changes from year to year. In Portugal it was -0.2% in 2014, but it was 3.6% in 2011. Likewise in the UK it was 1.5% last year, but 4.5% in 2011.
Prices have risen throughout history. The pound, for example, lost 99% of its value in less than a century. You may not worry about what will happen in 100 years’ time, but inflation can have a significant effect on your capital in your lifetime. There is no predicting now what it will be in five, 10, 20 or 30 years’ time. Yet you need to plan for inflation over these years, since it will affect the spending power of your savings in your later years.
Official figures are based on a basket of goods containing a representative selection of items for people across all ages and incomes. It rarely reflects our personal inflation rate, which is generally higher than the official one.
Inflation is insidious. To illustrate the potential effect, a personal annual rate of 4% would reduce the spending power of 100,000 (Euros or Pounds) to 81,537 after just five years. After 10 years it falls to 66,483. After 20 years it will have lost 56% of its value. If your personal rate is 5%, then 100,000 would be worth 59,874 in 10 years and 35,849 in 20.
Even lower rates have an impact over time. 2.5% inflation reduces the spending power of 100,000 to 77,632 in 10 years and 60,269 in 20.
With more and more people living 30 years in retirement, you need to plan for this possibility. Thirty years of inflation could decimate your savings if they do not keep pace with inflation. A 4% rate would wipe out over 70% of the value of 100,000 over the period, taking it down to just 29,386. It would even lose over half its value with a lower rate of 2.5%, ending up being worth 46,788.
Larger amounts are not immune. A research paper by First Direct illustrated how a million is not what it used to be, with inflation downgrading the lifestyle it can buy you. The value of £1 million in 2012 was worth £2.6m 20 years previously.
In 1992 £1 million could buy you a basket of goods including an average house in Kensington and Chelsea, a Rolls-Royce, a seagoing luxury yacht and holiday homes in Tuscany and Cornwall. In 2012 it could buy an average house in Hounslow, an Aston Martin and a river cruiser. It is a similar story here in Portugal.
All this means that you need to plan to protect your savings from inflation. You need enough capital growth to at least keep pace with inflation, and preferably beat it. So keeping the bulk of your wealth in a bank account is not the answer. Cash is not a risk-free investment because it loses value each year.
It is increasingly important to plan your affairs with longevity in mind. And there is second threat to plan for – taxation. You need a tax informed investment strategy with the potential to provide capital growth higher than inflation and where your money is legitimately protected from unnecessary taxation. This can be achieved with a diversified investment portfolio, based on your attitude to risk, personal circumstances and aims, and placed within a tax efficient arrangement which is compliant in Portugal.
By Gavin Scott
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Gavin Scott, Senior Partner of Blevins Franks, has been advising expatriates on all aspects of their financial planning for more than 20 years. He has represented Blevins Franks in the Algarve since 2000. Gavin holds the Diploma for Financial Advisers. | www.blevinsfranks.com