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Investment view

The problem with having different inflation figures is you can use whichever suits your purposes, says Brian Tora.

What exactly is the rate of inflation? I know the Chancellor now uses the consumer price index for the purposes of setting a target for the monetary policy committee but does that paint a sufficiently accurate picture of what is happening to the cost of living? To what extent should investment planners take into account the other measures that are available?I was put in mind of this by a letter from my local authority stating that it will be limiting this year’s increase in council tax to the rate of inflation – 3.1 per cent. The problem with having multiple choices for such an important statistic is that you can quote whichever suits your purposes best. In this case, although the letter makes no mention of which it is, I suspect the retail price index has been used.

Do not forget, there is also RPIX or the RPI less the effect of mortgage repayments. And there is the rub. If you are allowing for inflation when making a finance plan, you need to take into account whatever elements of the rising cost of inflation will be affecting your clients. This is particularly important in retirement planning.

Last week saw the publication of UK inflation data for December. The CPI inched ahead to 1.6 per cent while the RPI also recorded a modest increase from 3.4 per cent to 3.5 per cent. But the real jump came in the RPIX rate from 2.2 per cent in November to 2.5 per cent in December. Which of these do you think most truly reflects the rise in the cost of living for your clients?As it happens, colleagues in our research department wrote a paper on the effects of inflation just a few weeks ago. Issued during Christmas week, it almost passed me by. Indeed, had I not been so incensed by what I considered misinformation from my local authority, I might not have dug it out. But dig it out I did and fascinating reading it made.

For example, did you know that wealthier households have the highest rates of inflation? At least, that is the conclusion of a study carried out in 2002 by the Institute of Fiscal Studies. The reason, according to the findings, is that wealthy people spend less on goods than services, which have been subject to higher inflation in recent years. Between 1976 and 2000, the average annual inflation rate for the richest 10 per cent of households was 7.14 per cent compared with only 6.77 per cent for the poorest 10 per cent.

You may not consider the difference that significant but, compounded over a period of time, it would make a significant difference to the amount of income that a portfolio needs to generate. But the real point is that there is no such thing as a typical household. We do not all buy the same goods and services.

In the days when we could more easily rely on a final-salary pension to deliver an inflation-proofed income, the problem of accounting for a rising cost of living was less acute. While recent low inflation takes away some of the pressures, they still persist in some measure. Aside from anything else, lower inflation means lower investment returns. In the longer term, it is likely to mean slower growth in dividends.

The traditional way of coping with inflation was to favour equities over other asset classes. Nowhere was this carried out with greater enthusiasm than in the UK pension industry. The bear market that ushered in the new millennium, along with greater transparency and more demanding regulation, has exposed the limitations of this approach. Even so, equities still top the tables when it comes to achieving excess returns over inflation in the long term.

As it happens, this outperformance is slim over anything except cash. While, admittedly, the data published in this survey was collected over varying timeframes, it nevertheless paints a believable picture. Equities weigh in at an 8 per cent excess return, commodities at 7.8 per cent, commercial property at 6.8 per cent and even bonds deliver a healthy 6.3 per cent, helped by the strong bull market that accompanied the collapse in interest rates during the 1990s.

The message is clear. No single asset class should be relied on as a hedge against inflation. Diversification is crucial. Even lower-volatility of bonds can play their part. It all supports the case for professional investment planning. But be careful what statistics you use.


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