Propose planning and investment measures to protect a client's purchasing power from being eroded by inflation
The idea
Planning should be done in real terms: goals, spending and withdrawals indexed to inflation. Real return = (1 + nominal return) ÷ (1 + inflation) − 1, so 6% nominal with 3% inflation is about 2.91% real. Tax makes this worse because it is levied on nominal returns: taxed at 30%, the 6% becomes 4.2% and the real return falls to about 1.17%. Investment measures include inflation-linked bonds, real assets, equities over long horizons, shorter-duration fixed income and inflation-linked annuities. Planning measures include a flexible spending rule and preserving human capital. The trap is holding large cash or nominal bond balances as the safe choice for a long-lived client, which quietly loses purchasing power.
Formulas
Real return from a nominal return
(1 + nominal) ÷ (1 + inflation) − 1
- nominal
- the return as reported
- inflation
- the inflation rate over the same period
Plan spending in real terms. Subtracting inflation from the nominal return overstates the real return, by more the higher inflation is.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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