Inflation adjustment clauses are nothing new to contracts but what is uncommon is the high rate of inflation that we’re currently experiencing and just how fast that inflation is is rising. So whereas before it wasn’t as important, now it’s imperative because if if an inflation adjustment isn’t accounted for, the receiver of money stands to lose a lot of the value of the contract.
You may have heard of the term nominal value nominal value is the face value stated on the contract. For example, if I purchase a service every month for 1500 dollars, $1500 is the nominal value of that contract, but we can’t go by nominal value alone especially for longer term deals because again we stand to lose a tremendous amount of money if we do.
So in this video we’re going to go over three key considerations for any inflation adjustment clause in a contract.
First you need to have a basis for the rate of inflation and this is this is really really important because this determines how much the contract will be adjusted for. Now traditionally this has been the consumer price index or CPI but as more people are realizing this isn’t a viable method more accurately calculating inflation because the CPI skews the true rate of inflation and the skew results in an understating of the inflation.
So one alternative is shadowstats.com and this has CPI charts that better reflect the real rate of inflation.
As another option you can create your own indices slash formula for calculating inflation and as another option you can use a flat percentage such as 7% or whatever it is that you’d like and then you could also have the option to opt into a higher percentage if your formula for inflation exceeds that fixed rate.
But the key is that you have a reliable and agreed upon method for calculating the adjustment for inflation as the payee the person receiving the money, it’s important that you note negotiate for the true rate of inflation versus what’s traditionally been accepted. So CPI has traditionally been accepted fixed rate has traditionally been accepted but if you if you if you take if you accept those two methods for calculation you stand to lose significant value from a contractor.
Another key consideration is the adjustment frequency so you need to rest if you late how often the adjustment takes place this is actually very important so the first layer to frequency is whether something is a one time payment or adjustment or is reoccurring. If reoccurring at what interval is it? Monthly, quarterly, biannually, or annually now again traditionally inflation adjustment as it has taken place annually but in practice it’s worth accelerating payments for the payee because if adjustment expectation surprised the payer of money to pay or especially after an extended.
The payor may decide to breach the contract or they may just not be able to pay so you have to take in to account practical considerations here and that’s why you know this is a new environment for for many people and so when accounting for frequency it’s good it’s beneficial to the payee that it that payments are made in more frequently.
Now it’s not just because the payments are made more frequently but you have to take into account that if the bill becomes do after a long period and it’s a let’s say it’s 75% more than the the payor had anticipated, they may be rethinking this whole contract and whether or not they like this adjustment inflation adjustment clause at all.
Because you have to remember people will not be accustomed people are not accustomed to just how high and quickly inflation is increasing so you you want to take into account practical considerations and that’s just a general that’s a general good rule for contracts – it’s not just having the language in there being technically right it’s being practically considerate and knowing ahead of time in advance, okay I may have this accounted for in my contract, but if the other party is going to be jolted by this then it’s it won’t bode well for me whether in terms of getting paid or initiating litigation it might it might end up causing litigation because the other party will say, well this isn’t fair I didn’t this is you know maybe outside of what we consider where they may start arguing over whether the formula is being calculated accurately.
So this is this is a practical consideration but again it comes back to how often annually has been traditionally the route and I think that’s that’s a long time to wait especially in this environment.
The third the third consideration is the direction of adjustment and this is not nearly as important but it’s what has happened in the past is the there has been a provision for weather the basis for adjustment yields a a negative number so in this case the the contract would be less than the nominal amount because of maybe for some reason it’s it’s actually the the formula that is used for the basis for inflation actually has a negative yield and so while it is unlikely especially right now, it is possible especially over the short term so as the receiver of money obviously it’s best if this isn’t contemplated in the contract. You only want a situation where the contract is either paid out as the nominal valuable value states or you there’s an adjustment based on how much additional inflation erodes that initial value of the contract.
So you want the contract to either stay the same or where where you only stand to gain as the payer it’s to your benefit to have this contemplation in the contract especially for larger contracts because there there it is feasible it is it is possible that there’s some there is some instance whereby especially if you have a if you have a a formula that’s taking into shrink into account different considerations it is possible that there is a circumstance where especially if it’s a if the inflation adjustment is calculated in the short term that there is some situation where there would be a return on money so it is good to have it both ways if you’re the payor.
However it is unlikely that in this environment that you would see that money back so with this comes opportunity right when we’re dealing with we’re talking specifically about contracts.
There are different sides to this and so as the receiver of the money as the payee it’s important that you and that you alert the pay or that this is not a concession – this is merely maintaining the value of the contract.
So practically if I were to approach a a contract negotiation it would be to me it would be a given like how are we going to adjust inflation for this and as the payer obviously you want no clause because or a fixed clause like 3% and and at the worst case like if you were really conceding you would base it on CPI because again CPI suppresses the real inflation rate.
When we when we are going to the grocery store we are much more aware of how what the real inflation rate is because we can we we know from month to month hey we I only I paid $9.99 for this two months ago and now it’s $12.99. So that’s not an 8% it’s not a 8% inflation right it’s it’s much more but CPI has a way of skewing skewing the basket of price goods that it’s based upon to be much lower than the true rate of inflation so as the payer of the contract you want something like a fixed clause like 3% you want to go the traditional route.
And if you can get no cause at all you stand to gain tremendously right because we’re going to see the the value erode from that nominal price so with that as I was mentioning there is tremendous opportunity as you’re looking in the marketplace if you can get deals especially over the longer term where inflation adjustment is to a low fixed amount such as a fixed clause or it’s it’s to the CPI at worst or if it’s just not contemplated.
And it’s it’s only based on nominal value you stand against tremendously there’s a there’s a tremendous discount there now you need to account for maybe that is built into the contract you need to account for it you know it because a price adjustment can be built into a contract in other ways so it could be the cause there could be a cost of goods clause and that would be a way of a contract accounting for inflation in some regard now on the other side of this you do have to keep in mind that you don’t want to have clauses that are stacking on one another.
So if you have an inflation adjustment clause and a clause for a cost of goods you could end up paying multiples over what you should be doing So what what the idea here is that this is a way for the payee to maintain the relative value of a contract throughout the contract this is not a game this is not a way to make money it’s simply a way to prevent the erosion of the value.
It is a very interesting contemplation now in 2022 and 2023 as we have seen inflation continue to rise I think that may take a you know we we we may see that slow down or or stop altogether but it ultimately will pick up so I think what what will end up happening is will we will ultimately come to the question of what do we want to what what what is the currency that we want to base this contract on but that’s down the line.
But right now what is happening is we need to make sure that our contracts whatever the contracts maybe that what we are agreeing to the value maintain is it is maintained throughout the contract because if one party if one party has no if the payee does not negotiate in a an inflation inflation adjustment clause they stand to lose a tremendous amount of value oh.
And if you would like a summary of what I have talked about in this video if you go to inflationadjustment.com, I will make that freely available no subscription required it will be on there and furthermore if you’d like to contact me my contact information will be at inflationadjustment.com