Know Your Own Inflation Rate

Jason Stipp: I am Jason Stipp for Morningstar. Although the government releases its official inflation data every month, and that data has been within, what they call an acceptable range, a lot of consumers, especially retired consumers and investors, seem to have a different sense of how hot inflation has gotten recently.

Here with me to talk about that disconnect and how to customize the actual inflation to your individual situation is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, the Federal Reserve does say that the official inflation rate, the CPI, is within an acceptable range, yet when you look at some of the costs out there at the gas pump and the grocery store, it feels like there is some sort of disconnect. Why is it that the official rate seems to be lower than what we're actually feeling out there?

Benz: Well, a couple of things, Jason. First of all, the Fed considers the core inflation rate. So excluding those food and energy cost that we all have to pay for when it's looking at inflation targets, but the other thing--and this is an important concept that Jason Zweig has highlighted in his Wall Street Journal column--is, this concept called "Meflation."

So, really our individual inflation rate is going to vary depending on what kind of stuff we're buying and what our main household expenses are. So, for some people, inflation may seem relatively high. So if it's a senior, for example, where those food and energy costs are a very high proportion of their total household outlay, inflation will be much higher for them than for households where those costs aren't as big a percentage. So, it really is something that you have to customize and think about that personalized basket of goods and services that you are buying.

Stipp: So, let's talk about some of those swing factors and what can cause your Meflation, as Zweig would say, to be higher or lower. The first one that we will talk about is location, where you live. How does that affect the inflation?

Benz: Well, a big one is if you have a fixed rate mortgage or if you're retired and your home is already paid for. That's a good thing because you won't experience those household housing costs fluctuating to the extent that would happen if you had an adjustable rate mortgage and were paying rent. So that's a good thing if you've got those costs locked down.

But you might also see your housing costs vary from one region of the country to another. So, for someone who is living in an area that's on an economic upturn, so maybe the D.C. area or the Bay Area right now, folks like that who are paying rent will tend to be confronting higher housing-related costs than people who are in more economically stable or even depressed areas.

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Stipp: Another thing I know that we have in Chicago is sometimes there will be legislation to help seniors or people in retirement keep some of those fixed housing costs down?

Benz: Right. So, the property taxes can be a big component of retirees' budgets. I know from my own mom and dad, they are still in the house that I was raised in. It's a large home, and their property taxes are a big percentage of their household income. But you may be able to qualify for senior freezes and other programs like that that can help you keep your property taxes down. If you do, that's a good thing and that's one reason you may not have to be as concerned about inflation as someone who does not have such programs in effect.

Stipp: Another big swing factor in your personal inflation rate is health-care cost. I know it's a biggie for everyone, but especially so for retirees. What do you need to think about there?

Benz: Well, if you're someone who is lucky enough to be able to rely on a former employer's health-care plan into retirement--and that's a dwindling group these days--but someone like that would have to be relatively less concerned about medical cost inflation. That's a big cost for a lot of retiree households.

Another group that wouldn't have to be as concerned would be someone who had bought a long-term care policy with an inflation rider; that person would have bought themselves some important insulation against rising nursing home and other long-term care costs.

Stipp: So lastly, Christine, as you are thinking about that personal rate of inflation, has to deal with the choices that you make and how willing you are to make them. How can I help to buffer my inflation impact by making some of those choices?

Benz: This is an issue that has recently gotten a lot of attention, because lawmakers are looking at actually adjusting the extent to which social security payments are adjusted for inflation based on consumers' willingness to make these substitutions.

So, I guess when thinking about your own inflation susceptibility, think about how flexible you are when you make choices. So, if you are a household that has to have Heinz Ketchup, and you won't substitute even if the other brands are on sale, then you'd want to budget for maybe higher inflation cost than if your household was very flexible and willing to make substitutions.

Stipp: So, we talked about a few of the things that might affect how much inflation you might see. So, let's talk about how protected you are from your sources of income to be able to withstand some inflation, because you're likely not going to be able neutralize all of that, even if you do change some of the choices that you make.

I think some of the big ones to talk about first are the non-portfolio-related sources of income that you have. What did you think about there as you're thinking about how protected you are from higher prices?

Benz: Well, anyone who has social security has a nice buffer there against higher prices, because social security does include a cost-of-living adjustment. Seniors aren't getting it this year, but they should get it in the years ahead if inflation does go up. So, if that social security paycheck is a big proportion of your total income needs, you're in good shape as far as inflation is concerned. If it's just a tiny portion of your total income needs, you're not in as good a shape.

If you're receiving a pension with an inflation adjustment--and not all pensions do include that inflation adjustment--that's another positive that will help you stave off inflation, and the same goes for folks who have an annuity with an inflation rider. They will have some protection against inflation. If you don't have those sources of inflation protection built in, you'll need to build a greater bulwark against inflation in the future.

Stipp: What about for folks who are maybe still in the employment force? We know greater numbers of folks who are near retirement age might be working longer. How would that affect the adjustments you might make?

Benz: Well, that's a great point, Jason. So, if you are still working, either full-time or part-time, you'll be able to potentially get a cost-of-living adjustment in your paycheck. So, if you are doing that, that is another one of those bulwarks against inflation; that's a positive for you. If you're not working and not eligible for those cost-of-living adjustments, you'll need to plan for inflation accordingly.

Stipp: So, take a look at some of those non-portfolio income steams to get a sense of how protected they are.

Let's turn and talk a little bit about your portfolio and how to gauge whether your portfolio is really built to withstand what your customized Meflation might be. What should you look at there? Where should you start?

Benz: Well, I think you really want to think about the composition of your portfolio. I've recently written about how the safe stuff, things that we think of as safe, so cash and short-term bonds, really may not be that safe when you factor in the threat of inflation long term. So, if a high proportion of your portfolio consists of short-term bonds, cash, even intermediate-term bonds without any inflation protection built in--so maybe you don't have any TIPS exposure--you want to be really careful because inflation is going to gobble up a big percentage of that return and maybe then some. So, that group of investors needs to be on high alert against what inflation could mean to their portfolio's real returns.

On the other hand, if you are someone who has a high percentage of your portfolio in stocks, or maybe retirement is several years into the future, and you are still sticking with a stock-heavy portfolio, you probably need to be less concerned.

Stipp: And what should you think about time horizon? So, a lot of folks have much longer to invest and they have a greater time horizon, they maybe do hold more stocks.

But how should you factor in that as you're thinking about the inflation protection in your portfolio and how much you need?

Benz: It's a good question. So I would say for seniors who are quite far into their retirements and don't anticipate having a long time horizon for their investment assets, probably need to be less concerned about the toll that inflation will take over time.

But if you are just starting out in retirement and maybe retire for 30 years, you really do need to plan for inflation-proofing that portfolio, because over time, even a seemingly benign inflation rate of 3% or so is really going to take a bite out of that portfolio and any return that it might earn.

Stipp: So they call it the magic of compounding when you are saving and investing, but it's sort of an evil spell in reverse when it comes to inflation.

Benz: Exactly.

Stipp: All right, Christine, with some very interesting tips on customizing the inflation rate and also battling them in your portfolio. Thanks for joining me today.

Benz: Thank you, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.