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
Retirement Needs = Inflation Adjusted Income * 25
Retirement 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!
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 …