THE HOUSEHOLD INFLATION INDEX - Tilney · PDF file · 2017-10-16The Household...

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THE HOUSEHOLD INFLATION INDEX

Charting the rising cost of living

2 THE HOUSEHOLD INFLATION INDEX

Contents

3 Foreword

5 Introduction

6 Executive summary

8 Whatisinflationandhowisitmeasured?

10 Part 1 – How different households spend their money

14 Part2–Howdifferenthouseholdshaveexperiencedinflation

20 Part3–Implicationsofinflationandhowtofuture-proofyoursavingsand investments

26 Conclusion

27 Appendix

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Foreword by Andy Cowan Head of Financial Planning at Tilney

At Tilney, we recognise that everyone’s future is personal to them, whichmakesitpersonaltous.Weknowthereisno‘onesizefitsall’solutiontofinancialplanning;everyonehasapersonalstory,agoal for the future that’s individual to them. We have been around for over 180 years and have helped thousands of people achieve financialpeaceofmindandsecuretheirfinancialfutures,throughourexpertfinancialplanningandinvestmentmanagement.

At the beginning of 2017, we launched The Cost of Tomorrow report, which examined how much we spend across our lifetime, and what our future household spending will be in retirement. By highlighting what our futures might cost, we can help clients to plan theirsavingsandinvestmentssufficientlytoday,tosupporttheirpersonal dreams and ambitions for the future.

Oneofthebiggestinfluencesonyourfinancesisinflation.Ithurtsyour buying power, puts a squeeze on your standard of living, and for those approaching or in retirement, savings pots will buy less as time goes on.

So,inourlatestreport,theHouseholdInflationIndex,weexplorehowinflationhasimpactedhouseholdswithdifferentlevelsofincome over the last 20 years and reveal who has had to work hardest to maintain their standard of living, and why.

Lookingbackattheimpactofinflationoverthelasttwodecades,and in particular, what happened during the economic downturn, providesaninterestinginsightintothepressuresourfinancesmaycome under over the coming months and years. By understanding in moredetailhowinflationcantakeabiteoutofourlivingstandards,we can help clients to protect their money from rising prices and the ravagesofinflation.

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Introduction

Inflationremainshighonthenewsagenda.Afterfallingtorecordlowsinrecent years, in part due to sharp falls in the price of oil, the current political and economic uncertainty which has pushed up the costs of incomes, means a renewed squeeze in our standards of living as wage growth lags UKinflation.Buthowmuchdoweunderstandtheimpactinflationhasonourhouseholdincomesandwhatexternaleventscaninfluencetherateofinflationweeachexperience?

TheHouseholdInflationIndexexamineshowinflationhastightenedthe purse strings of UK households over the last 20 years. It examines how households across different income brackets spend their money, to determinehowandwhytheirexperienceofinflationdiffers,andbyhowmuch.

We explore how households devote their budgets to essential and discretionary spending, eg housing, utilities, food and drink, transport, holidaysandeducation,todeterminehowinflationhastakenhold.

Not only does the data show how households at either end of the income spectrumhaveexperiencedfasterratesofinflationthanatypicalhousehold,with the wealthiest 10% having to work hardest over that period to maintain theirstandardofliving,butwealsorevealsomeinterestingtrendspre-andpost-recessionacrosstheincomegroups,aspricesriseandfallacrossspending categories.

Against a backdrop of Brexit uncertainty, volatile currency markets, slow wage growth despite low unemployment, price hikes on many imports andtheprospectofinterestraterisesinthenot-too-distantfuture,understandingmoreabouttheimpactinflationishavingonourpersonalpockets now and in the future is vital, if we are to maintain living standards in the months and years ahead.


Executive summary

Wealthiest households hit hardest by inflation

• In the last 20 years, the wealthiest 10% of UK households (earning £78,500pa+) havebeenhithardestbyinflation,atarateof64%.Thelowest-incometenth (less than £10,400pa) have seen inflationof53.8%,whilethetypicalincomehousehold(earning£26,900-£30,000pa)hasseeninflationof50.7%–thesefigureshavebeencalculatedusing ONS data from the last 20 years.

• Overthe20-yearperiod,inflationhasbeenagameoftwohalves;thetop10%sawthehighestinflationintheeconomic boom up to 2007, and the bottom 10% have felt price rises pinch hardestpost-recession.

• Rising housing costs made the biggest impact on all income groups. For the wealthiest tenth, the next two biggestinflationcontributorshavebeen holidays (112%) and education (326%), thanks to soaring independent school fees.

• Households need to protect themselves againstinflation,withaninvestmentportfolio including assets which can eitherbeatinflationorareprotectedfromit;examplesincludeequities,index-linkedbondsandrealassetssuch as gold.

What determines a household’s individual rate of inflation?

• Inflation,anincreaseinpricesandassociated fall in purchasing power, is calculated by looking at the changing prices of the items in an average household’s basket of goods and services.

• But in reality, every household spends money in different ways, so every household has its own individual rate of inflation.

• Crucially, the mix of items in your own basket, combined with the changing prices of your goods and services, determinesyourinflationrate.

• Household income is a vital differentiator-itaffectsnotonlyhowmuch is spent overall, but crucially, the mix of goods and services bought.

• Wealthier groups devote a greater share of their budget to discretionary spending (like holidays, buying cars or payingschoolfees),whilelower-incomegroups devote a greater share of their budget to essentials such as utilities and food.

Why has inflation differed between separate income groups?

• Since 1997, rising housing costs made the biggest impact on all income groups, but the top 10% felt them hardest, because they spend more of their housing budget on buying homes, which have risen dramatically in price, rather than maintenance or renting, which have risen more slowly.

• From2007-2016,thebottom10%feltinflationthemost,becausetheyspendthe most proportionally of any income group on utilities, which shot up in price overthedecade;foodinflationalsohitthem harder.

• Other than housing, the two biggest contributorstoinflationexperiencedby the wealthiest income group have beeneducationandholidays;thankstosoaring school fees (which have risen

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more than fourfold in 20 years).

• For typical income households, insurance and running the family car havebeenmajorinflationcontributors;the bottom 10% has been hit hard by a 149% increase in utilities prices.

How has the cost of different items changed over the last 20 years?

• Certain ‘big ticket’ items have actually fallen in price over the last 20 years: cars are 12% cheaper today than they were in 1996 (once quality improvements are factored in), benefitinghighandmiddle-incomeearners, who are more likely to purchase new cars.

• For the top 10%, the falling cost of cars has deducted 6.7% from their total inflationfigure,whereasforthebottom10%, the deduction is just 2.7%.

• Prices for consumer electronics fell every year and are now 85% cheaper thantheywerein1996onalike-for-likebasis.Thishasbeenmoreofabenefittolower-incomehouseholds,whospendproportionally more of their budget on electronics.

• Clothing prices have halved in 20 years, a boost for all households, though the wealthiesthavebenefitedmost,sincemore of their budget is devoted to this spending category.

• Since the Brexit vote, there has been a slowdown in house price growth in some parts of the country, and a rise in thepriceoffoodandnon-foodessentialitems;wealthierhouseholdsarelikely

to be coming off best from these trends due to their spending mix, however, the fall in sterling has also made holidays moreexpensive,amajorinflationcontributor for wealthier households.

How to inflation-proof your finances

• Whenplanningforinflation,householdsshould not be distracted by what’s happeningintheshortterm;inflationhasrisensignificantlyinrecentmonths,but it is impossible to predict how it will behave for the next 20 years.

• Households should protect themselves againstvaryinglevelsofinflationbykeeping a limited amount of money in cash,whichiserodedbyinflation,andby devising an appropriate investment strategy.

• Tobeatinflation,aninvestmentportfolio must include assets with inflation-beatingorinflation-proofingcharacteristics, for example:

- Equities, which have repeatedly, significantlyoutpacedinflation

- Index-linkedorinflation-linkedbonds – or ‘linkers’ – are designed to mitigateinflation

- Real assets such as gold are immune to a sharp depreciation in the value of paper money

- Investment in infrastructure projects, whichtypicallyinvolvelong-termcontracts that provide annual adjustmentsforinflation.

TheTilneyHouseholdInflationIndexcloselyfollowstheOfficeforNationalStatistics’methodofcalculatinginflation,but importantly also includes the full cost of buying homes, right back to 1997.


Nevertheless, consumer price indices provide vital information about how the economy is faring. They are used in many ways by the Government, businesses and society: they affect interest rates, taxes,incomes,pensionsandbenefits,and are built into millions of contracts of many different kinds. These indices alsoshowtheimpactofinflationonourfamily budgets and affect the value of the pound in our pockets.

Trackinginflationisacomplexundertaking,towhichtheOfficeforNational Statistics (ONS) devotes considerable resources. To do so as accurately as possible, ONS compiles a basket of goods and services that represents the UK’s spending habits, and records price changes for each over time. ONS then groups some together into a singleinflationfigure,suchas‘cinemas,

theatres and concerts’, while others, for example ‘butter’, appear on their own. They are all then combined into a single measure for the whole economy.

That sounds simple. But the basket contains over 700 separate items, measured in more than 20,000 outlets nationwide. Moreover, what we buy changes all the time, so the basket must constantly be rejigged, adding new items that are cementing their place in our shopping habits and dropping those that have fallen out of use. Then there is quality. A modern LED colour TV today is vastly superior to an old cathode ray tube one from 20 years ago, but might cost about the same. ONS attempts tomakeadjustmentsthatreflectthehigher value improved quality delivers, so that a TV that might have the same price ticket over time, is actually getting

Economistsdescribeinflationasageneralincreaseinprices,and associated fall in the purchasing value of money. We all understand what that means in our daily lives, but it’s a slipperyconcepttonaildownintoactualhard figures.

What is inflation and how is it measured?

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cheaper once that higher quality is taken into account. The same applies with pack sizes. Chocolate manufacturers have famously been shrinking their bars recently in the wake of the pound’s devaluation, but keeping the retail price the same. That is, in effect, a price increase, and ONS treats it as such.

Officialconsumerpriceinflation(CPI)is,however, no more than a general yardstick. What we buy depends on our age, the size of our family, where we live in the country and, of course, our incomes. That means weallexperienceinflationindifferentways, so our standard of living is impacted on an individual basis by changing prices. We must each, therefore, make ourownplanstoinflation-proofourownfinancial future.

Our methodology

Our methodology closely follows the ONS’s, except that we are looking at inflationforparticularincomegroups,rather than the overall average. We use the various ONS price series, applied to spending baskets for each group based on thefigurespublishedintheannualFamilySpendingsurveys.Wehavere-orderedsome of those basket components to matchourfirstCostofTomorrowreport,published in early 2017. In doing so, we collect together spending items that form a distinct category that we all recognise. For example, our category Holidays, includes items found under several different headings in the ONS data. We have also included housing costs in a more comprehensive way than regular

CPI, allowing for the full costs of home purchase and ownership to be included directly since 1997, alongside rent and maintenance. Our method produces very similar results to CPIH, ONS’s new measureofinflationthatincludeshousingcosts, but our measure dates back to 1997, whereas ONS has a series dating back only to 2005.

In addition, we make two key simplifications.First,wehaverebasedthebasketonlyeveryfiveyears,lessregularly than ONS. Over 20 years this simplificationcreatesadifferenceof only about one percentage point, however,whencomparedtoofficialCPI.Secondly, we have used more than one price series within a single category only where households of different incomes have a distinctive spending mix within that category (irrespective of the actual amount they might spend). So, for example, within our Transport category, we track vehicle purchase and operationseparately,becausehigher-income households devote a larger share of their transport spending to buying new vehicles, while those with lower incomes spend a larger share operating them. In clothing by contrast, the mix is rather similar, so we do not break it down.

We follow three groups of households, the middle 10% (the median, or ‘typical’ household, earning between £26,900 and £30,000),thetoptenth(thehigh-incomehouseholds, on £78,500 and above) andthebottomtenth(thelow-incomehouseholds, on less than £10,400).

TYPICAL HOUSEHOLD

from £26,900 to

£30,000

LOW-INCOME HOUSEHOLD

on less than

£10,400

HIGH-INCOME HOUSEHOLD

on £78,500 and above


PART 1

Higher income households

almost

higher than the

over the last

15%TYPICAL HOUSEHOLD

hit hardest by

Before we look at how prices have changed over the last 20 years for each of our three incomegroups,weshouldfirstunderstandwhat they spend their money on, as this will determine why their respective experiences ofinflationaredifferent,andbyhowmuch.

How different households spend their money

20yrsINFLATION

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Chart 1 and chart 1a show what the spending basket looks like for each group. Note that it is not a measure of absolute spend (chart 2), but of the mix of spending. The absolute level is not relevant for calculating inflation,onlytherelativeamountsin the basket. For example, the wealthiest households spend more in cash terms on alcohol than the other groups, and by quite a large margin, but it is a much smaller share of their overall spending. It is themixthatmattersforinflation.

As we can see, housing takes the largest bite for all the groups, but beyond the roof over their heads,

each spends its money in rather different ways. For example, typical households, and those on the lowest incomes, devote the next largest part of their budgets to food, but this is onlythefifthlargestcategoryforthehighest earners. By the same token, paying for electricity, gas and water consumes almost £1 in every £7 of the lowest incomes’ budgets, more than twice as much as the typical household, and compared to just £1 in every £27 spent by the wealthiest tenth.Thebetter-offdevote,bycontrast, a noticeably larger share of their spending to holidays, and education (of which the largest share is private school fees).

“ The absolute level is not relevant for calculating inflation,onlythe relative amounts in the basket.”

Chart 1 - Spending Mix 2016

Top 10% Typical household Bottom 10%

Housing 28% 25% 22%

Utilities 4% 7% 13%

Food & drink (ex alcohol) 7% 12% 16%

Alcohol & tobacco 1% 3% 4%

Clothing & shoes 4% 4% 3%

Household goods & services 7% 6% 5%

Health & personal care 3% 4% 3%

Transport 11% 11% 7%

Telephone & internet 2% 3% 4%

Entertainment & recreation 8% 8% 7%

Restaurants & cafes 6% 6% 5%

Holidays 11% 7% 4%

Education 4% 1% 1%

Other 5% 5% 4%

Essentials 58% 66% 71%

Discretionary 42% 34% 29%

Source:TheHouseholdInflationIndex


Chart 1a – Spending Mix 2016

Holidays

Restaura

nts &

cafes

Education

Enterta

inm

ent & re

creatio

n

Telephone &

inte

rnet

Transport

Health &

personal c

are

Household goods &

services

Housing

Utiliti

es

Clothin

g & shoes

Alcohol & to

bacco

Food & drin

k (ex alcohol)

Bottom 10%Top 10% Typical household30%

20%

10%

0%

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cent

age

of s

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ix

Spending categories

Other

Chart 2 – Average Weekly Spend (2015/2016)


Housing £356 £128 £42

Utilities £47 £34 £26

Food & drink (ex alcohol) £91 £60 £30

Alcohol & tobacco £18 £13 £7

Clothing & shoes £53 £21 £7

Household goods & services £85 £32 £10

Health & personal care £34 £19 £6

Transport £139 £58 £14

Telephone & internet £23 £15 £8

Entertainment & recreation £103 £42 £14

Restaurants & cafes £77 £30 £11

Holidays £144 £37 £9

Education £52 £5 £2

Other £63 £25 £8

TOTAL £1,285 £519 £193

Essentials £742 £340 £137

Discretionary £543 £179 £56



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Per

cent

age

of s

pen

din

g m

ix

Type of spending

Chart 3 – Spending mix by income group

Bottom 10%Top 10% Typical household80%

70%

60%

50%

40%

30%

20%

Essentials Discretionary

In fact if we crudely group the spending categories into what is broadly essential spending (housing, utilities, clothing, petrol, public transport, and key personal and household items), this makes up two thirds of a typical household’s spending. Those on lowest incomes devote 71% of their spending to essentials, compared to only 58% of the top tenth. For the wealthiest, the remaining 42% of their spending, or £543 per week on average, goes on discretionary categories, which

include restaurants, education, holidays, entertainment, new cars, alcohol and tobacco, and household durables. Of course, you could easily argue that a large portion of food or clothing spending by the top tenth may be on more luxurious and therefore less essential items, or that houses need not be so expensive. This means their discretionary spend is in reality even higher, but the crudefiguresneverthelessserveasauseful illustration.



PART 2

Higher income households have experienced

inflationoneducationcosts in

thanks to soaring school fees

326%20yrs

There has been a surprisingly large divergencebetweentheinflationexperienced by the typical household, and those with the highest and lowest incomes over the last 20 years.

How different households have experienced inflation

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Those in the middle have seen theleastinflation,whilethoseat the bottom and the top have seen prices rise much faster, meaning they have had to spend disproportionately more money to maintain their respective standards of living.

Over the last 20 years, a typical household has experienced inflationof50.7%,basedon all its spending. Allowing for our more comprehensive treatment of housing costs thanofficialCPI,thisfigureis

closely in line with the ONS calculations1. However, those at the bottom of the income scale have seen the prices of what they buy rise faster than those in the middle, up 53.8% since1997,asignificantextraincrease given that this group spends all its income and has no financialcushion.Thosewiththehighest incomes, however, have experiencedthefastestinflationof all, with prices for what they buy soaring 64.0%.

1OfficialCPIiscalculatedforAllHouseholds(whichincluderichandpooralike).Tilney’scalculationswhenappliedtoallhouseholdscloselymirrorofficialCPI.Themiddleincomegroup,whichwediscusshere,experiencedslightlylowerinflationthanallhouseholdscombined.

Chart 4 – Inflation over 20 years

Bottom 10%Top 10% Typical household Bottom 10%Top 10% Typical household

70%

60%

50%

40%

30%

20%

10%

0%

5%

4%

3%

2%

1%

0

1996

1997

1998

1999

2000

2001

2002

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2004

2005

2006

2007

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2011

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1996

1997

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2004

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2013

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2015

2016

Chart 5 – Annual Rate of inflation over 20 years

Infl

atio

n

Infl

atio

n

YearYear

Source:TheHouseholdInflationIndex Source:TheHouseholdInflationIndex


We can see that different groups saw their cost of living rise more rapidly at different times, with the highest income bandhithardestbyinflationpre-recession and the lowest earners feeling thebiggestpinchafterthefinancialcrisis (chart 5). Wealthier households experiencedsignificantlyfasterinflationboth between 1997 and 2004 and in the last two years than other groups, but similar levels to the typical UK household at other times. This is not simply owing to the soaring cost of buying a home, to which wealthier households devote a larger share of their spending than others. A similar pattern shows up, though in a less extreme way, even if all housing costs are excluded. The lowest-incomehouseholds,bycontrast,experiencedfractionallylowerinflationin the earlier years, but saw their cost of living rise much faster later. They have faredsignificantlyworsethaneveryoneelse in the last ten years, particularly thanks to food and utilities prices, which were very subdued in the early 2000s, but took off in more recent years.

Chart 6 shows how each of the last two decades show a very different pattern for those on the highest and lowest incomes, the former seeing decelerating price rises, the latter seeing them accelerate. Meanwhile, the typical household saw prices rise at about the same rate in each ten-year period.

So what explains the inflation differences between income groups?

Chart7showstheinflationrateexperienced by our household groups in each category of their budgets, allowing for their own mix of spending within the categories themselves.2 So, for example, wealthier households have experiencedlessinflationinthealcoholand tobacco category because they spendlessthanlow-incomehouseholdson tobacco, which has risen sharply in price, and more on alcohol which has risen more modestly. The mix of spending in the clothing category is rather similar between income groups, so each household has seen the same rate of inflationforclothes.

How spending categories then combine tomakeupacompleteinflationratefor each group depends on their overall spending mix, as seen in charts 1 and 2. The big leap in education costs made almost no impact on the lowest earners, because they spend less than £1 in every £100 on it, but it took a sizeable bite out of the budgets of the top tenth, because this group is most likely to have children in private school, where fees have soared dramatically in recent years. High-earninghouseholdsspend£1in£25 on education on average. School fees andothereducationcontributedfivepercentagepointstotheinflationofthe

Chart 6 – Pre- and Post-recession inflation

1997-2006 2007-2016 1997-2016

Top 10% 33.0% 23.3% 64.0%

Typical Household 23.1% 22.4% 50.7%

Bottom 10% 20.9% 27.2% 53.8%


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highest earning of households (chart 8), but had only a negligible effect on other groups.

Thegreatestinflationforeachincome group therefore comes from those categories, where prices are rising fastest and which account for the largest share of their basket (charts 1 and 2). So if an item does not feature in a group’s basket of spending, or makes up only a very tiny share, it will make next to no contribution to their overallinflationrate,evenifithas risen hugely in price (see the education example above). By contrast, if something is a very large budget item, such as housing, then a price change willmakeasignificantimpactontheoveralltotalinflationrate for that household. So the soaring cost of housing dragsuptheoverallinflationrate for that spender. But, if an item has risen in price more slowly than everything else, or even fallen, such as clothing has done, it will drag thatperson’soverallinflationrate down. If someone spends more of his budget on clothing than others, he will therefore benefit disproportionately.

2 See notes on methodology – we have analysed some of the components of each headline category in detail where the spending mix within that category is very distinctive (eg Transport, Housing, Entertainment, Alcohol & tobacco). Where the spending mix within a category is similar, or no ONS data is available, we have used the ONS price series for the headline category (eg Food & drink, Clothing & shoes).

Chart 7 – Tilney Household Inflation - by spending category

1997-2016 Top 10% Typical household Bottom 10%

Housing 142% 98% 97%

Utilities 128% 139% 149%



Clothing & shoes -49% -49% -49%




Telephone & internet -4% -4% -4%

Entertainment & recreation -13% -12% 4%


Holidays 112% 89% 100%

Education 326% N/A N/A

Other 133% 140% 138%

TOTAL 64% 51% 54%

Thistableshowstheinflationratefor various categories of spending, for each income group. How these affect a household will depend upon the share of each spending category within that group’s overall basket, shown in chart 1. ONS shows that all income groups saw a similar rate of inflationforutilities.BUTthiswillbefelt less by the top 10%, who spend only £1 in every £25 on utilities, compared to the £1 in every £8 spentbythebottom10% (chart1).

Holidayinflationhas been similar for the top and bottom 10% income households. BUT it has a greater impact on the wealthy, who spend more than double the share of their total budget on holidays.



Although education had the highestrateofinflation,thebiggest single factor overall is housing. Total housing costs for the wealthiest group rose 142% over 20 years, much faster than for the typical UK household or thelowest-incomegroup.Thisisbecause wealthier households spend a larger share of their overall housing budget on buying homes, rather than just on maintenance, or on renting. Moreover, they devote more of their total spending to housing than other groups. These two factors combined mean that housing added 18 percentage

pointstotheinflationexperienced by the highest earners over 20 years, compared to just nine percentage points forthelowest-incomegroup(chart 8). The highest earners experiencedmostofthisrun-upinhousingcostsinthefirsthalf of the period. Since 2007, theirhousinginflationhasbeenwell below that experienced by the lowest earners, just 14%, compared to 21%. (Further detailonhowinflationbreaksdown by category in each of the twoten-yearperiodscanbefound in the Appendix)

Compared to the typical households, wealthier households have also experiencedhigherinflationfor their holidays and their household goods and services (in particular the services element). But once the weight of the various categories in their budgets is taken into account, household goods and services becomelesssignificant,withthe biggest contributors to theirexperienceofinflationafter housing, being education, holidays, and restaurants. It is these discretionary areas of spend that have kept their inflationhigherthanthatofother groups.

Bycontrast,forthelowest-income households, the biggest impact after housing has come from rapidly rising prices for utilities, and tobacco, once their spending mix is taken into account. For the typical household it’s keeping their cars on the road, which includes petrol costs, and insurance premiums, which have soared 200% over the last 20 years (chart 10).

Some prices have risen much more slowly than others, of course, and some have even fallen. Clothing costs have halved over 20 years, falling particularly in the early 2000s, as British consumersbenefitedfromever cheaper imports, before

Chart 8 – Percentage points added to or subtracted from inflation by selected spending categories


Household inflation 64% 51% 54%

Housing 17.9 9.7 9.1

Utilities 1.4 2.6 5.4

Food & drink -1.3 -0.3 -1.0

Alcohol -1.5 -1.0 -0.9

Tobacco 0.7 2.0 3.6

Clothing & shoes -10.7 -9.3 -9.7

Household goods -4.4 -3.1 -4.0

Health & personal care -0.9 -0.5 -0.7

Transport -3.1 -0.2 -0.1

Car purchase -6.7 -4.7 -2.4

Running a car 2.6 3.6 1.2

Telephone & internet -1.6 -1.6 -2.8

Entertainment & recreation -9.7 -8.6 -5.7

Restaurants & cafes 2.8 2.9 1.8

Holidays 3.5 2.5 1.3

Education 5.1 1.2 0.1

Insurance 2.8 3.5 2.7


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rising slightly in more recent years. Household appliances, textiles and homeware followed similar trends, though each to a different degree. In the entertainment segment, prices for consumer electronics fell in every year over 20 years, and are now a phenomenal 85% cheaper thantheywerein1996onalike-for-likebasis(ieoncequalityisfactored in). Cars are also 12% cheaper than they were 20 years agoonalike-for-likebasis.

These big shifts in the relative price of consumer goods have benefitedallourincomegroups.Clothing and entertainment have deducted most from the inflationexperienceofallofthem, though the wealthiest havebenefitedmost,sincetheyare in a position to consume more of these categories (see charts 8 and 11). The highest earnersandmiddle-incomehouseholds have also done very well from lower car prices. For the lowest earners though, who buy fewer cars, lower household electronics and homeware prices have been a bigger blessing.

While housing costs are the biggestinflationcontributorfor households of all incomes (chart 10), even excluding housing costs, the highest and lowest earners experienced fasterinflationthanthetypicalhousehold (chart 9).

Chart 9 – Inflation, excluding selected categories


Household inflation 64% 51% 54%

ex Housing 46% 41% 45%

ex Utilities 63% 48% 48%

ex Food & drink 65% 51% 55%

ex Alcohol 66% 52% 55%

ex Tobacco 63% 49% 50%

ex Clothing & shoes 75% 60% 64%

ex Household goods 68% 54% 58%

ex Health & personal care 65% 51% 55%

ex Transport 67% 51% 54%

ex Car purchase 71% 55% 56%

ex Running a car 61% 47% 53%

ex Telephone & internet 66% 52% 57%

ex Entertainment & recreation 74% 59% 60%

ex Restaurants & cafes 61% 48% 52%

ex Holidays 61% 48% 53%

ex Education 59% 50% 54%

ex Insurance 61% 47% 51%

Chart 10 – Top Contributors to Inflation for Each Income Group, 1997-2016

Top 10% Typical Household Bottom 10%

Housing Housing Housing

Education Running a car Utilities

Holidays Insurance Tobacco

Chart 11 – Top Subtractors from Inflation for Each Income Group, 1997-2016

Top 10% Typical Household Bottom 10%

Clothing & shoes Clothing & shoes Clothing & shoes

Entertainment & recreation Entertainment & recreation Entertainment & recreation

Car purchase Car purchase Household goods





PART 3

While the highest income households have experienced the greatest amount of inflationoverthelast20years,it’spossiblethatlow-incomehouseholdshavefeltmoreimpacted by it.

Implications of inflation and how tofuture-proofyour savings and investments

EQUITIES, INDEX-LINKED BONDS, REAL ASSETS SUCH AS GOLD

To beatan investment portfolio must

include assets such as

INFLATION

21

As more of their spending is devoted to essentials, they cannot easily adjust what they buy when prices move, and also have less money left over at the end of each month, while top earners are cushioned by their income.

When the Bank of England sets interest rates, with the goal of keepinginflationclosetoitslong-termtargetrateof2%,itnaturally focuses on an overall average for the country. But this means that some groups will see their cost of living rise more than others. The Government then determines to what extent policies can protect those on the lowest incomes, and those in the middle. Naturally, policymakers are less concerned about price rises for high earners, as households in this group may be better able to absorb these, andcanplantheirfinancestoprotect themselves from the long-termeffectsof inflation.

Whenplanningforinflation,itiseasy to be distracted by what’s happening in the short term. We know that the weakening of sterling following the Brexit votemeansinflationiscurrentlyelevated. History tells us that different income households

will be feeling the impact of this elevatedinflationindifferentways. For example, there has been a slowdown in house price growth in some parts of the country, while the weakening of the currency has made food and non-foodessentialitemsrisein price. Wealthier households are likely be faring best from both trends, as they spend proportionally more on housing and less on essentials. However, the fall in sterling has also made foreign holidays more expensive, amajorinflationcontributorforwealthier households.

Theseshort-termeffectsof Brexit may be impacting households’day-to-daylivingnow, but they will not help to plan for the future. There are various triggers, such as a return to higher interest rates, whichcouldinfluenceinflationover the next 20 years, but it is impossible to predict how different income groups will be affected. What households can do, though, is arm themselves againstvaryinglevelsofinflationwithacarefullythought-outfinancialplan.


Their current position

James and Judy are both members of their employer pension schemes. James and his employer each contribute 5% of salary into his pension and its current value is £120,000. His wife contributes 5% of salary and her employer 3% of salary into her pension scheme. The value of her pension fund is £30,000. They anticipate that their salaries will increase withinflationof2%(BOEtarget).

They both anticipate receiving the maximum State Pension of £158 per week (£8,216 per annum)fromtheir68thbirthdays.Thisentitlementwillincreasewith2%inflation.

What do they need to achieve their goal?

In order to achieve their retirement objectives, they will require their pension plans to produce an average annual investment return of 6% per annum (net of charges). To achieve this, they should think about the following:

• An investment portfolio with circa 75% in equities. A growth portfolio is likely to be appropriate for them.

• If they aren’t comfortable with that level of risk in retirement, they might want to reduce the equity exposure to about 50%, but may also have to reduce their income requirements in later years.

• They should try to avoid using ‘lifestyle’ strategies within their pension arrangements, as these will result in their assets being switched into lower-riskcashandfixed-interest assets as they approach their normal retirement age.

CASE STUDY 1: James Smith, Marketing manager Goal: To retire in 20 years, aged 60

James wants to retire by the

time he is 60 with an income of

£30,000 (net)

per annum in today’s terms

Assuminginflationof2.5%,

he will actually require a net

annual income of

£49,000

at age 60 to preserve the ‘real’

buyingpowerintoday’s terms.

He earns

£70,000

a year as a marketing manager

and his wife Judy earns

£40,000

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So how can you inflation-proof your finances?

Indevelopingaplanforfuturefinancialsecurity,itisvitalthatafinancialplannerunderstands your personal lifestyle aspirations and goals, while factoring inthepotentialimpactofinflationover time.

We work with clients to get a deep understanding of their personal circumstances, and use specialist softwaretoproduceacashflowmodelof their potential future income and expenditure.Thisbringstheirfinancestolife, enabling us to see how these could pan out over time, to look at different scenarios and to identify any shortfalls in funding well ahead, so that this can be addressed either through making further investments, perhaps postponing their planned retirement date or making changes to their spending patterns.

This type of analysis can also help those who may be overly cautious about their financestoidentifyopportunitiestoretire earlier than they anticipated or where they may have scope to enjoy their money-forexample,onaholidayhomeor worldwide cruise – as well as to gift money to their children or grandchildren.

Life can of course throw up unexpected events such as ill health, redundancy, a windfall from an inheritance or business sale, or a change in family circumstances such as the birth of a new child or divorce.Ourfinancialplannerscanthereforerevisitaclient’scashflowmodelperiodically to make sure their plan is still on track to meet their objectives, or take account of any change in circumstances.


Their current position

MrJoneswasamemberofhisemployer’sfinalsalarypensionscheme,andthisprovideshimwithanetannualincomeof£20,000,whichwillincreasewithinflation.

They have obtained State Pension forecasts, and Mr Jones will receive a pension of £5,000 and Mrs Jones £6,500 from their respective 66th birthdays. Mrs Jones has built up a pension fund of £400,000.

To maintain their standard of living, Mr and Mrs Jones, both aged 60, want to generate an annual income of £40,000 (net).

What do they need to achieve their goal?

They have an immediate shortfall in income of £20,000. They could consider the following:

• MrsJonescouldwithdrawhermaximumtax-freecashentitlementof£100,000tofundthisshortfalloverthenextfive-yearperiod.

• She could then withdraw a further £24,000 in income at age 65 to fund the shortfall until their State Pensions commence, at which point she will withdraw £10,000 per annum.

• Mrs Jones has always taken a speculative approach to investing her pension fund, and has typically held more than 90% in a portfolio of equities. However, in retirement she requires only an annual investment return of 3% (net of charges) to be attained to both meet her income requirements and preserve the capital value. Therefore it would be advisable to invest in a more cautious manner to reduce the potential for large falls in value. Her portfolio could comprise of 40% equities, with the remaining balance investedinfixedinterest,propertyandhedge funds.

CASE STUDY 2: Mr & Mrs Jones, retirees Goal: To maintain an annual income of £40,000 (net)

£

25

Choosing the right investment strategy

When it comes to choosing the right investment strategy, it is imperative to seektodeliveralong-termreturnthatexceedsthepotentialimpactofinflationonyour lifestyle. While it is important to hold sufficientfundsincashtomeetday-to-dayneedsandanunforeseenemergency-suchasanunexpectedlossofemployment-oneof the biggest mistakes many people make is to hold too much in cash for long periods of time, where the real spending value will begraduallyerodedbyinflation.Savingsand investments need to deliver a return commensuratewithinflationjusttostandstill in real terms.

We believe in building and managing diversifiedinvestmentportfoliosthatcanpreserve and grow the real value of our clients’ wealth over time. To achieve this, portfolios typically invest across a range of asset classes such as equities, bonds, absolute return funds and property.

There are a number of asset classes that canprovideinflation-beatingorinflation-mitigating characteristics:

• Equities. Over long periods, equities have repeatedlyandsignificantlyoutpacedinflationasbusinessesinvestinexpansion,and as the dividends they issue to shareholderscaninturnbere-investedto further compound growth. Academic studies have shown that over the long term, most of the real return from equities, after theimpactofinflation,hascomefromthe impact of dividend reinvestment in compounding returns.

• Index-linked bonds. Bonds are effectively IOU notes which pay the holders interest until the loan is paid off. They can be issued by both governments, eg UK gilts, and businesses, where they are referred to as corporatebonds.Risinginflationisbadnews for most types of bond which pay afixedlevelofincome,asitmayreducethe attractiveness of the level of income provided on a bond, especially if the rate ofinflationmoveshigherthantheyieldon a bond. However, certain types of bond knownasindex-linkedorinflation-linkedbonds – or ‘linkers’ – are designed to provideinflationprotectionbyadjustingthelevelofincomepaidoutandfinalvalueofthe bond when it is repaid.

• Gold. Real assets such as gold have long been regarded as a store of value in the event of a sharp depreciation in value of paper money, a potential major source ofinflation.That’sbecausewhilecentralbanks, such as the Bank of England, have the capacity to create more money in circulation either electronically or by printing more notes, gold is a physical asset.

• Infrastructure. Infrastructure projects, such as managing toll roads, ports and airports or running hospitals and prisons, typicallyinvolveverylong-termcontractsand often these will provide annual adjustmentsforinflation.Inaninvestmentportfolio, infrastructure can be accessed throughstock-exchangelistedinvestmentcompanies that invest in such projects.


ConclusionUnderstanding the impact of headline rates of inflationprovidesausefulyardsticktofuture-proofyourfinances.Butarguablyamoreusefulbenchmark, is to understand how and why your householdrateofinflationdiffers.Thisthenarms you with the ability to take the necessary steps to protect your standard of living now, and in the coming years.

The last 20 years portray an interesting story, when we consider how the macroeconomic and political landscape has weighed down on individual households’ standard of living, and how different income groups have fared throughout those events. As our research shows, wealthier households have experienced farhigherratesofinflationthaneveryoneelseover the last two decades, not least because of their exposure to the soaring costs of buying a home, but also due to the proportion of their income devoted to holidays and education. Price rises in these categories have meant that higher earners have had to spend disproportionately more than any other income group to maintain their standard of living over the last two decades. However, over this period, wealthierhouseholdshavealsobenefitedfromrising asset prices including strong returns on property, stock and bond markets.

So what does this mean in real terms for people planningtheirfinancesnowandforthefuture?Whilewecannotknowhowinflationwillbehavefor the next 20 years, we can say with some confidencethatthetop10%arelikelytofeelthe pinch more than typical households. Their expenditure on property, education and holidays means that they will inevitably experience a higherrateofinflationthanaverage,unlesssomething drastic affects the price trends of

these spending categories. By contrast, we canassumethatlow-incomehouseholdsarelikelytohavebornethebruntofinflationmorethan the typical household since Brexit, due to thecurrency-inducedpricerisesoffoodandother imports, though with sterling beginning to strengthen, this may soon subside.

When looking ahead for the next 20 years, financialplanningisvitaltoensureyoushelteryoursavingsandinvestmentssufficiently,sothat any returns are able to negate the eroding impactofinflation.Forthosestillsavingforretirement, this means having an investment portfoliowhichincludesinflation-beatingassets such as equities, as well as real assets such as gold, which can act as insurance against currency depreciation. Those already retired may no longer face the same education and housing costs, but should appreciate that their spending mix – heating bills, holidays, travel insurance and healthcare – means they may still be experiencing a higher rate of inflationthanaverage.Astheyarenolongerearning, this group needs to generate an income from assets and investments which beats their individuallevelofinflation,tomaintainthesame standard of living.

At Tilney, your personal wealth is our personal responsibility. And while there is no one solution that provides guaranteed protection againstinflation,ourfinancialplannerscanprovide the advice and expertise to steer your savings and investments in the right direction, to fund the cost of today and tomorrow.

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Appendix

Table 1 – Inflation breakdown by category, 1997-2006

Table 2 – Inflation breakdown by category, 2007-2016


Housing 113% 77% 63%

Utilities 49% 52% 53%




Household goods & services -1% -5% -4%



Telephone & internet -18% -18% -18%

Entertainment & recreation -11% -10% -3%


Holidays 51% 51% 51%

Education 76% 76% 76%

Other 57% 59% 59%

TOTAL 33% 23% 21%




Housing 14% 12% 21%

Utilities 53% 57% 63%







Telephone & internet 17% 17% 17%

Entertainment & recreation -3% -2% 6%


Holidays 40% 26% 32%

Education 141% 141% 141%

Other 48% 51% 49%

TOTAL 23% 22% 27%



T: 020 7189 2400 E: [email protected]

t i lney.co.uk

6ChesterfieldGardens,Mayfair,London W1J 5BQ

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