Planning for Inflation

Inflation is one of the most significant factors affecting long-term financial planning. While often overlooked in favor of more exciting topics like investment returns, failure to properly account for inflation can devastate a client's retirement income, education savings, or other long-term goals. CFP professionals must understand how to incorporate inflation into every aspect of financial planning.

Historical Inflation Context

Understanding historical inflation provides the foundation for making reasonable assumptions about future inflation. The US Bureau of Labor Statistics tracks inflation through the Consumer Price Index (CPI), with data available since 1913.

Long-Term US Inflation Averages

Planning Assumption: For long-term financial projections, most CFP professionals use 2.5% to 3.5% as a reasonable inflation assumption, with 3% being the most common default.

Rule of 72 for Inflation

The Rule of 72 helps clients understand inflation's impact on purchasing power:

Years for Prices to Double = 72 / Inflation Rate

At the historical average of 3.1%, prices double approximately every 23 years. A 65-year-old retiree can expect prices to nearly double by age 88.

Sector-Specific Inflation: Healthcare and Education

Two critical areas for financial planning - healthcare and education - consistently experience inflation rates that exceed general CPI. Failing to account for these higher rates leads to significant underfunding.

Healthcare Inflation

Healthcare costs have historically outpaced general inflation by a significant margin:

Healthcare Planning Implications:

• Retirement healthcare projections should use 5-6% annual inflation
• Medicare premiums increase faster than Social Security COLAs
• Long-term care costs rise even faster than general healthcare
• Early retirees (pre-Medicare) face full exposure to healthcare inflation

Higher Education Inflation

The Higher Education Price Index (HEPI) measures inflation specifically for colleges and universities:

Education Planning Implications:

• Use 4-5% inflation for college cost projections
• HEPI is more accurate than CPI for education planning
• Public vs. private institution costs may inflate at different rates
• Room and board costs often rise faster than tuition

Real vs. Nominal Returns

Understanding the difference between real and nominal returns is essential for accurate financial planning.

Definitions

• Nominal Return: The raw percentage gain on an investment, not adjusted for inflation
• Real Return: The return adjusted for inflation, representing the actual increase in purchasing power

The Real Return Formula

Precise Formula:

Real Rate of Return = (1 + Nominal Rate) / (1 + Inflation Rate) - 1

Example: If an investment yields a 7% nominal return and inflation is 3%:

Real Return = (1.07) / (1.03) - 1 = 3.88%

Simplified Approximation (for quick calculations):

Real Return = Nominal Return - Inflation Rate

Using the same example: 7% - 3% = 4% (close to the precise 3.88%)

Exam Tip: The precise formula is more accurate, especially when dealing with higher inflation rates. The approximation works well when both rates are relatively low (under 5%).

Real Return by Asset Class

Historical real returns help set appropriate expectations:

Critical Insight: Cash and money market funds often produce negative real returns, meaning they lose purchasing power over time even while generating positive nominal returns.

Inflation-Protected Investment Options

Several investment vehicles provide explicit or implicit inflation protection:

Treasury Inflation-Protected Securities (TIPS)

• Principal adjusts with CPI
• Interest paid on inflation-adjusted principal
• Guaranteed by US government
• Available in 5, 10, and 30-year maturities
• Suitable for conservative portfolios seeking inflation protection

Series I Savings Bonds (I Bonds)

• Composite rate: fixed rate + inflation rate
• Currently attractive during elevated inflation periods
• $10,000 annual purchase limit per person (plus $5,000 with tax refund)
• Tax-deferred, potentially tax-free for education
• Cannot be redeemed for 12 months; early redemption penalty

Equities as Long-Term Inflation Hedge

Over extended periods, stocks have historically outpaced inflation:

• Companies can raise prices to offset input cost inflation
• Dividends tend to grow over time
• Real assets (property, equipment) appreciate with inflation
• Short-term: equities can suffer during unexpected inflation spikes
• Long-term: equities provide one of the best inflation hedges

Incorporating Inflation into Financial Plans

Retirement Planning

When projecting retirement needs:

1. Estimate current expenses in today's dollars
2. Project to retirement date using appropriate inflation rate
3. Continue projecting through retirement (25-35 years)
4. Use real return rates for investment projections, OR
5. Use nominal returns with inflation-adjusted spending needs

Example: A client needs $60,000 annually in today's dollars. At 3% inflation over 20 years until retirement:

Future Annual Need = $60,000 x (1.03)^20 = $108,367

Over a 30-year retirement, this amount must continue to grow to maintain purchasing power.

Education Planning

For education funding:

1. Use HEPI rate (4-5%) rather than general CPI
2. Start with current costs at target institutions
3. Project forward to enrollment year
4. Consider that costs continue rising during 4+ years of enrollment
5. Factor in potential merit aid or financial need changes

Healthcare Planning in Retirement

Healthcare requires special attention:

1. Use 5-6% annual inflation for healthcare costs
2. Remember Medicare premiums increase faster than benefits
3. Plan for potential long-term care needs (higher inflation)
4. Consider Medigap or Medicare Advantage premium increases
5. Out-of-pocket costs (deductibles, copays) also inflate

Common Inflation Planning Mistakes

Current Economic Context (2025-2026)

As of late 2025, the inflation environment shows:

• Headline inflation: 2.7% (November 2025)
• Core inflation: 2.6% (excluding food and energy)
• Fed target: 2.0% average over time
• Fed projection for 2026: Elevated, around 2.8-3.5% per J.P. Morgan forecasts
• 2026 Social Security COLA: 2.8% (announced October 2025)
• Professional forecaster 10-year outlook: 2.38% average CPI

The Federal Reserve continues working to bring inflation back to its 2% target, but most economists expect inflation to remain above target into 2026 due to tariff impacts and persistent services inflation. For financial planning purposes, using 3% as a baseline assumption remains prudent.

Key Takeaways for Exam and Practice

1. Always use real returns when showing clients projected purchasing power
2. Healthcare and education require higher inflation assumptions than general CPI
3. The Rule of 72 helps clients visualize inflation's long-term impact
4. TIPS and I Bonds provide explicit inflation protection for conservative investors
5. Long-term equity exposure provides implicit inflation protection
6. Test plans under multiple inflation scenarios to ensure robustness