The Role of Inflation in Retirement Planning – Why Reducing Nominal Risk can Increase Real Risk

In order to improve consumers’ and advisors’ ability to make decisions in retirement planning, they need to understand the return potential and the associated risks of the respective products. Usually, risk-return indicators are based on nominal measures derived from the probability distribution of nominal wealth at the end of the product’s term. For consumers, however, real benefits (i.e. the benefits in “today’s purchasing power” adjusted for inflation) are more relevant than nominal benefits. We show that real risk-return characteristics can be structurally different from nominal risk-return characteristics. Hence, typically used nominal risk-return indicators can misguide consumers. Under certain circumstances, a product that is less risky than a competing product in nominal terms can be riskier than the competing product in real terms.

We analyze different aspects of nominal vs. real risk-return characteristics that are relevant for long-term savings processes. First, we derive from economic arguments and existing literature why the return of certain assets, particularly stocks, exhibits a positive correlation with inflation over long periods of time. We argue that such long-term effects need to be considered in an analysis of long-term savings processes. Secondly, we introduce a capital market model that implies such a positive correlation over long time horizons and analyze how fundamental (simple) results change if we focus on real returns. For instance, we analyze how the real risk and return of a simple mix between a bond and a stock deviates from the well-known nominal result. We also determine the stock ratio of the utility maximizing portfolio in the famous Merton problem when utility of the real benefit is considered. Thirdly, we analyze how the real risk-return characteristics of typical retirement savings products deviate from the nominal counterparts. We particularly show that, under certain circumstances, an increase in (nominal) guarantees can increase real risk. Note that here (as in all our analyses), we assume that – as is currently the case in practice – guarantees of typical products are given in nominal terms and bonds with nominal notional values are used as “safe assets”. Finally, we derive implications for consumers, financial advisors, and policy makers.

Find the Q&A here: Q&A on 'Pensions - Inflation and Data Analytics'