Have you ever received a measly CPI-adjusted wage rise and felt like the headline inflation rate bears as much relation to your cost of living as a neanderthal tribe does to the Rich Kids Of Instagram?
CPI inflation and its RPI cousin measure the average change in prices for a representative basket of goods and services bought by UK households. This average figure is highly unlikely to match your spending habits.
In fact, it would be extraordinary if it did.
Perhaps you don’t smoke, or drive, or have a pet. Maybe you’re a vegetarian, or don’t consume prescription drugs at the ‘average’ rate. Or you could spend more on housing or less on food than is assumed by the official inflation rate methodology.
My personal inflation rate is closer to Afghanistan’s national figure than the UK’s.
The reality is that official inflation metrics aren’t designed to reflect your specific situation. And the difference can have a big impact on your investing plans.
Best practice calls for us to adjust our investment contributions and target numbers by inflation. Updating like this keeps your portfolio on track to deliver the purchasing power you need in the future.
Given it’s your own future at stake, it’s far better to correct drift using your personal inflation rate than to use CPI or RPI.
Inflation is an insidious money-munching monster. Innocuous differences between your rate and the official statistics can have a disproportionate effect on your lifestyle given time.
For example, the historical UK inflation rate of 3% will halve your purchasing power in 22 years and nine months.
But a personal inflation rate of 5% halves your spending power in 13 years!
With a healthy lifespan, you could be exposed to inflation for more than 70 years over your combined accumulation and deaccumulation phases.
It’s worth working out what you’re really up against.
What is a personal inflation rate?
Your personal inflation rate measures the change in prices that are representative of your precise spending patterns. That’s as opposed to the official inflation figures, which calculate the national average.
Your personal inflation rate accounts for how your situation diverges from the national picture due to your:
- Demographic and gender
- Level of affluence
- Housing choice
- Brand preferences
- Product and service preferences
- Choice of vendors
- Ability to switch to cheaper products or take advantage of offers
- Ability to substitute – for example to switch to pork if steak becomes too expensive
If you spend more on items with large price increases in comparison to the national average, then your personal inflation will outstrip the official number.
If you spend relatively more on items with low price rises then you will experience a lower rate of inflation.
Remember, we tend to be susceptible to the money illusion. This is our very human habit of valuing our wealth in nominal terms (the figure before inflation adjustments) instead of real terms (our actual purchasing power).
The money illusion gets worse as you age. Your price perceptions are partially anchored by the past. It can be hard for even the money-savvy to update their outmoded notions, such as that a pint of milk should cost 20p or a cinema ticket no more than half a farthing.
The illusion can be broken by knowing your personal rate of inflation.
How to calculate your personal inflation rate
Calculating your personal inflation rate starts with tracking your spending.
You can use an online budget tracker or customise your own spreadsheet.
The simplest method is to capture your total annual spend, then calculate its percentage change every year.
Year 1 total spend = £30,000
Year 2 total spend = £33,000
Percentage change = (33,000 – 30,000) / 30,000 x 100
= 10% annual personal inflation
This crude method has a problem, though. Many people’s annual spending is pretty volatile.
For instance, my annual spend shot up 44% one year, then down 16% the next. I’m not advocating I should have increased my investment contributions by 44% in a year and then slashed them by 16%!
(The technical term for that is “nuts”.)
What’s needed is a personal inflation method that smoothes out our consumption patterns.
Our expenses can be quite benign some years. Other years the consumption gods hit you with spendy thunderbolts like replacing the roof in the same year you get married.
We need to account for that variation.
Two ways to stop your personal inflation rate whipsawing
One method is to track a subset of your everyday expenses and to exclude large and infrequent purchases.
The Everyday Price Index maintained by the American Institute for Economic Research excludes items such as car purchases, appliances, furniture, and housing.
What’s left on your budget tracker will be a reasonable indicator of your inflation rate. It won’t be suddenly blown out of all proportion because you moved house one year.
The second method is to include your large and infrequent purchases, but to notionally spread the cost over time. This enables you to flatten out major expense spikes into a smoother series of annual expenses. You can insert these into your personal inflation calculation.
If you buy a new car worth £10,000, say, and intend to keep it for 10-years then it shows up as a £1,000 expenditure every year.
Obviously this is a guesstimate. Much depends on how much you spend on a car next time.
Official inflation indexes can understate inflation if a consumer product improves in quality but doesn’t drop in price.
You get more for your money, and that shows up in the index as a decline in inflation (according to some methodologies).
But say you pay £1,500 for a laptop, and you spent £1,200 on the equivalent model five years ago. You’ll experience personal inflation even if it’s twice as good as your old laptop.
You can adjust for this ‘hedonic inflation’ by annually noting the prices for similarly-featured, brand new versions of your big-money, irregular expenditures.
The £1,000 per year expense for the car, in the example above, would be upweighted if newer versions of the same model rose in price.
Granted, doing this takes some work. But your personal inflation rate will be more accurate in return for a bit of light Googling.
Alternatively you can assume you’ll stick to your current price point and accept a more basic product than is widely available next time.
That will be an interesting test of your frugal muscle.
Once in a lifetime
You can disregard costs for genuine one-offs for the purposes of personal inflation. Ignore the cost of your wedding or laser eye surgery, and assume you’ll never move house again.
Just make sure those costs are genuine one-offs.
Being sensible about what you ignore will help dampen your personal inflation rate volatility without torpedoing its accuracy.
Personal inflation annual average calculation
Once you have a few years of data, use a geometric mean calculator to reveal your average annual rate of personal inflation.
You’ll now have a good sense of how your personal inflation stacks up against the headline rates.
My average annual inflation rate is 6.38% vs 1.34% for CPI over the seven-year period I have good spending data for.
I’ve stayed ahead of inflation by increasing my income by an average of 8.25% per year. But I’ll have to get a grip on my personal rate if I retire early.
I can’t expect my portfolio to punch the lights out enough to cope with that level of inflation when headline rates are so low.
You can benchmark yourself against the UK inflation rate of your choice by visiting the ONS’ inflation page.
Slice and dice
It can be pretty revealing to chop up your spending data into categories. You can then analyse your inflation rate at a more granular level.
My annualised personal inflation rate for groceries is 4.85%. Knowing this figure has given me fresh impetus to rein in the food bill as it’s one of my biggest spending categories.
Utilities spending has declined by 5.51% annualised over seven years. I even impress myself with that. My gut would have said I’m burning money on heating. My gut is a notorious pessimist.
I’m going to credit this spending decline to the power of annual switching and installing the most efficient boiler that I could. I also installed smart heating controls.
How to use your personal inflation rate for investing
Adjust your key investing numbers by your personal inflation rate on an annual basis:
- Investment contributions
- Your investment target total
- Your target income to achieve financial independence (FI)
Step 1 – Add your end of year one personal inflation percentage to 1.
For example, 5% inflation: 1 + 0.05 = 1.05
Step 2 – Multiply your year one investing contributions by that annual inflation number e.g. 1.05.
For example, £500 monthly investing contribution:
500 x 1.05 = £525 investing contribution per month in year two
Step 3 – Next year, multiply year two’s investing contribution by the end of year two’s personal inflation number.
For example, if year two personal inflation is 4% then:
£525 x 1.04 = £546 investing contributions per month in year three
Personal inflation rate calculators
The only functional UK personal inflation rate calculator I can find is provided by UK fund manager’s Rathbones.
It still requires you to track your spending. Rathbones is pretty vague about the methodology.
The BBC host an ONS personal inflation rate calculator but it looks defunct.
There are a few US personal inflation rate calculators. They’re liable to be misleading as they try to squeeze you into Moses baskets representing different US inflation profiles.
Remember, relatively small divergences can devalue your wealth many times during a human lifetime. For this reason you’re better off calculating your personal inflation rate by hand.
Don’t blow yourself up
As investors and FI hopefuls we’re rightly warned to fear inflation like a baby chimpanzee is taught to fear snakes. Inflation is the serpent in the garden ready to make off with our nest egg if we’re not wary.
We’re too easily lulled by low official numbers. Meanwhile our goose is being cooked by a personal inflation figure nobody talks about. (Because if you do, people shoot themselves in the head.)
If you already track your spending then calculating your personal inflation rate is easy.
If you’re not tracking your spending – you should be!
Take it steady,
P.S. – I love this little detail about the RPI basket of goods from a paper on inflation:
Changes in the price of bacon are represented by back bacon and gammon: it is assumed that other cuts of bacon will, on average, move in line with these two items.
Jim O’Donoghue, Matthew Powell and David Fenwick. “Personal Inflation: Perceptions And Experiences.” 2007.