Most people that I talk to seem to misunderstand inflation and how to apply it to thinking about your retirement …
… the easiest way to deal with this is to think of inflation in TWO pieces:
1. Leading up to retirement (a.k.a. “life after work”)
2. After you have stopped working
It should be easy to see why:
In the former you are working with a stream of income (e.g. your salary) trying to build up to something big (i.e. your ‘nest egg’) …. whereas, in the latter you are working with a FIXED amount of money (i.e. your nest egg) and are trying to create an annuity stream (i.e. a pseudo-salary).
Can you see how one is almost the exact reverse of the other, yet inflation plays a HUGE – but different in effect – part in both?!
Today, we’ll deal with leading up to retirement:
Dealing with inflation in the planning towards your Number (i.e. your nest egg) is dealt with quite elegantly (for the mathematically-minded) in this post by Pinyo:
Step 1: How much do I need today?
I need $40,000 per year
Step 2: Adjust for inflation.
Now we have to adjust that $40,000 for inflation. For this example, we assume inflation rate is 3.5% per year. We accomplish this with the following formula:
Inflation Adjusted $ = Today’s $ * ((1 + inflation rate)^ Number of years to retirement)Inflation Adjusted $ = $40,000 * (1.035 ^ 30)
Inflation Adjusted $ = $113,000 (rounded up)
I need $113,000 per year after inflation
Step 3: Multiply by 25
The formula:
Retirement Needs = Inflation Adjusted Income * 25Retirement Needs = $2,825,000
I need to save $2.8 million to begin retirement
I can’t get the math to work, but you need to visit Pinyo’s post for the full explanations and try it for yourself …
We have some slightly different rules:
For example, I presume that inflation will be at least 4% for the next X years (economists were predicting 5+%, but who knows now, given the current economic situation?!) and I have been assuming a ‘safe retirement withdrawal rate’ of 5% (i.e. Rule of 20). Together, these come to a slightly lower ‘number’ than Pinyo, but not by much: $2.4 million. That’s why, for planning purposes, I don’t get too hung up on what numbers you decide to choose …
That’s also why I find that for us non-mathematically-minded-people [AJC: yes, I have 2nd year college math and I still can’t add in my head … let me see 1 + 3 = $7 million … good enough for me! 😉 ] that the following table is ‘good enough’ to estimate for inflation; if you earn $40,000 per year (or whatever you currently earn, or want to earn when you retire), then to estimate how much income you need to replace:
• 5 years out, add 25% to the current amount.
• 10 years out, add 50% to the current amount.
• 20 years out, double the current amount.
30 years out, we would simply multiply by 2.5 (which ‘only’ gets us to $100k, rather than Pinyo’s $113k). Again, for planning purposes, I actually think that this is close enough … but, if you are good with a calculator (or, better yet a spreadsheet), go for it!
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In the next and final part of this two-part series, we will look at how to deal with inflation after you stop work / retire …
@ KC – Thanks; I can’t seem to access (needs permissions set up) … so, I presume other readers will have same problem?
@Adrian – here’s the link to the spreadsheet on Google Docs:
http://spreadsheets.google.com/pub?key=rf4WOBG64CWR5_4Ojmlye1g&output=html
To help you and others get the same result as Pinyo I’ve put in a column headed “Factor” with a single value that you can simply key to your desk calculator then multiply by the amount you want per year and its all done !
For instance, if you are aged 30 and you want to retire at 65 then there’s 35 years until retirement.
Look along the row with 35 in column A, and the factor value is 98.65.
If you want $40,000 per annum when you retire then multiply the amount you want by the factor and there you are !
98.65 * 40 000 = 3 946 000.
If you want $70,000 then do:
98.65 * 70 000 = 6 905 500
which seems about right as its just under double the value we saw at 40,000.
So that factor figure should make doing the sums quicker and easier.
Earlier I had some problems as I couldn’t believe you just multiplied the Inflation Adjusted figure by 25 come what may.
Then I realised it was simply implementing the “4% rule”. You’re only advised to withdraw 4% of your final nest-egg in the first year of retirement. So if you want to keep to that rule, then obviously your nest-egg has to be 25 times bigger than the first amount you withdraw in the first year. Then it made sense.
Presumably, though, if your nest-egg doesn’t grow somehow (e.g. thru bonds or whatever) then it will be gone in 25 years if you withdraw 4% a year, so you won’t look forward to your 90th birthday !
And if anyone is just one year from retiring, look at the low figure you’ll need for your nest-egg at the bottom of the spreadsheet.
KC
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