Is a gallon of milk the same price it was when you were a kid? How does the price of an average car, house, etc. compare to that time? Does anyone else remember when gasoline could be had at the pump for less than $1/gallon? Chances are that things cost more now that when you were younger. This phenomenon is known as inflation which can be defined as the general increase in the price of goods and services over a period of time.
Inflation affects the amount of purchasing power that you will have, and should be of significant concern if you are planning to save for retirement. Why? For starters we are living longer, and this gives inflation a longer time to catch up and eat away at your purchasing power.
There are a number of people that mathematically define the real return as:
Interest rate of the investment – inflation rate = real return
Financial planners when figuring out the next effects of an investment will use the following formula to determine the real return:
(1+ interest rate of investment)/ (1+ inflation rate) = (real return + 1)
For the sake of argument, I will follow the formula preferred by financial planners.
Let us say you have an investment with a post-tax return of 7%, and that you believe that inflation which has been 3% for some time is actually going to be closer to 4% due to what is regarded as an increased inflation rate for seniors.
The net effect would look something like this:
(1+.07)/ (1+.04) = 1.02885 (rounded) OR a Real Return of 2.885%
Now the mathematically inclined will probably begin to see the problem relating to withdrawal rates. If you are only adding 2.885%/year in value, and are taking more than that out, eventually you are going to run out of money. As a famous Englishman once wrote “there’s the rub.”
Most people have nowhere near that amount of savings needed to deal with taxes, inflation, and a sustainable withdrawal rate.
If I needed the equivalent of $50,000 per year using the previous assumptions adjusted for inflation without having to worry about depletion of resources, I would need to save over $1,733,102.
If my after tax rate of return is worse than that or inflation is higher, this number is substantially increased.
For example, let us assume that I still need $50,000 per year and I can only find an investment with an after tax rate of return of 5% and inflation remains at 4%.
Now we have a real return of .9615 (rounded) or .962%.
To be able to not worry about funds running out at this rate, we would have to have $5,197,505.
Now perhaps you can see why financial planners are concerned.
On a positive note, if you are able to get a substantial return, of 9%. The amount you would need to have $50,000 per year is significantly reduced, because now you are getting a real return of approximately 4.808%
To be able to not worry about funds running out at this rate, we would have to have $1,039,933.
If we are not concerned about saving the principle, the amount of money that is needed is reduced as well. Given our increasing longevity, inflation should be a very real concern for retirees. The good news is that with proper planning and budgeting, it as a problem that can be solved.
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