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What Evensky Bakes in for Inflation

Jason Stipp

Jason Stipp: I'm Jason Stipp from Morningstar. As part of our Inflation Report, we're checking in today with noted financial planner Harold Evensky of Evensky & Katz Wealth Management to get his take on the inflation environment today and how he manages for inflation in his client portfolios.

Harold, thanks so much for calling in today.

Harold R. Evensky: Well, thanks for inviting me.

Stipp: First question for you is biggie. I'd like to start big picture with you. When you are thinking about inflation and inflation expectations as a baseline for client portfolios, what kind of numbers are you looking at? What kind of inflation are you expecting to see?

Evensky: Longer term our basic assumption is a 3% inflation rate, but all of our planning is done on the basis of real return. The logic of that: If we assume, let's say, the equity market will have a nominal return at 9%, we're really assuming a real return of 6%, so if we're wrong and inflation is 4%, we would expect a 10%. The point is, it gives us within a reasonable range, a fair amount of flexibility in terms of being wrong about our inflation guess.

Shorter term or maybe intermediate term, our probably biggest concern is high inflation, not hyper inflation, but high inflation--something in the maybe high-single-digits area. But longer term, we think 3% is a reasonable assumption.

Stipp: The follow-up question for you there. So, the CPI is considered one of the big measures for inflation and one that a lot of folks look to. But we also know that we've seen inflation much higher than CPI in certain areas, including health care and higher-education costs.

To what extent do you have to create a customized plan for folks who maybe are more exposed to these costs that are really moving up a lot faster than the average inflation rate?

Evensky: Well, first of all we believe that inflation for retirees is likely to be about a 1% higher. There is another index that typically runs about a 1% higher. When it comes to college funding, for our planning purposes, we use more than double the 3% assumption--we use a 7% assumption, and we use something similar for health-care cost.

So, when we are doing the actual planning, we separate those components of expenses out and inflate them in effect at a higher number.

Stipp: With respect to health care, there a few tools that are available to help investors manage those costs; one of them is long-term care insurance. Is that something that you take a look at as part of your planning and also do you look for an inflation component to that kind of insurance?

Evensky: The answer is we absolutely look at long-term care. We think that there is a market, that it's important. We think of it sort of as disability for the retired. If someone's assets are so small that paying for long-term care impacts their current quality of life, [we probably would not use long-term care insurance]. Many of our clients can self-insure. But for the broad spectrum of reasonably comfortable investors, long-term care is a critical part of the planning process.

In terms of building inflation in, if we can we'll use a policy that has an inflation rider in it. The alternative is to simply start off with a somewhat higher coverage amount. Keeping in mind that an investor doesn't need to cover 100% of long-term care through insurance. If they need long-term care, they are not going to be spending money going out to dinner and traveling. So it's trying to make it a guesstimate as to what the shortfall would be, if they need it. So we would look for significant deductibles, fairly long waiting periods, because what we are trying to do is get as much bang for the buck for catastrophic needs as we possibly can.