Financial planning takes the past, present and future of your finances into account. If you are only now establishing a financial plan, you might have debt burdens from the past, current living expenses from the present and retirement/ education planning for your future. Predicting the future with a high degree of certainty is not usually possible. However, there are ways to anticipate your financial future. This is where inflation forecasting becomes relevant in financial planning.
• Retirement planning
Retirement planning is a significant aspect of retirement planning. It involves projecting your future income and determining how you would maintain it (or even increase it) when you are no longer working. One of the ways inflation is used in retirement planning is in projecting the income you would need to meet your retirement goals. Someone without a known salary increase can use headline inflation as a benchmark. For example, a 34-year old who earns an annual salary of $40,000, can use an inflation rate of four percent to determine the par income at age fifty. In that example, par income would be $74,919. Determining the effect of inflation risk is another benefit of retirement planning, but that can be a separate role.
• Determining the effect of inflation risk
Inflation risk is a factor in investments as well as with retirement planning and other areas. In fact, inflation and taxation are two of the most corrosive risks of investing. Questions about the extent of inflation risk are answered by inflation forecasting. This helps financial planners and individuals to anticipate how much returns they need to cover such risks, or whether they make a real gain or real loss.
• Real gain or losses on investments
Establishing the extent of inflation risk helps in determining whether real gains are made on investments and how much of a real gain is made. With some investments, this involves discounting other factors like fees and taxes. However, discounting for inflation is a critical component as well. Inflation forecasting sets a discounting figure by which a future value can be translated into current purchasing power. For example, if an investment yields seven percent, but inflation is forecasted at five percent for the investment period, the real return on investment is a mere two percent.
• Enforcing prudence
Prudence in financial planning involves recognizing all risks and expenses while not overstating gains and income. Without factoring in inflation risk, a financial plan can be viewed with rose-tinted spectacles. Inflation forecasting serves to put the reality back into planning. Inflation forecasting helps persons to recognize that a dollar earned tomorrow might only be worth seventy cents today. This can help them to plan with that consideration.
Inflation forecasting is a useful tool that is used in many financial templates and calculators. It empowers investors by allowing them to set realistic goals with an awareness of inflation risk and its deleterious effect on income and investment returns.