An often overlooked component of retirement planning is inflation. So what exactly is inflation?
in·fla·tion [in-fley-shuhn] noun – In economics, a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency (opposed to deflation).
Interesting definition, but again, what does it mean exactly? The operative passage within that definition is loss of value. On a small-scale, over a short time period, the impact is generally insignificant. As an example, assume you deposited $100 in your local savings account on January 1st, 2016. You did not make any deposits or withdrawals. (Considering the interest rate paid on most accounts is negligible, we can put that aside.) According to the U.S. Bureau or Labor Statistics the inflation rate in 2016 was 1.26%.
On January 1st, 2017, how much money would be in that account? If you said $100, you are correct. The real question though is, “what is the relative value of that $100 one year later?” The answer is $98.76. See Figure 1 [Reduced Amount] below.
Figure 1 – Inflation on a Small Scale
Again, on a small-scale, over a short time period, the impact is generally insignificant. With that $98.76 (relative to the value a year earlier) you will be able to buy pretty much everything you bought last year. Moreover, when you are working, the impacts of inflation largely go unnoticed. Your wages generally rise as the costs of goods and services rise. Your earnings tend to keep pace with inflation, so normal inflation (1.26% in 2016) is not generally a concern.
However, when you adjust the scale (thousands of dollars) and time period (20 – 30 years) the impacts of inflation increase exponentially. In this second example, assume you desire a retirement income of $100,000. Suppose you want to retire in 20 years – and for planning purposes – you assume the average inflation rate will be similar to the previous 20 years. Checking the Table – Historical Inflation Rates, we see that over the 20 year period, 1994 – 2013, inflation averaged 2.425% (I have my inflation calculator set to 2 decimal places; therefore, the rate has been rounded up).
Note: There are numerous inflation calculators available for free online. Also, I include the inflation calculator shown in Figures 1 & 2 as part of the Budget and Retirement Planning worksheets available with my book, RENDEZVOUS WITH RETIREMENT: A Guide to Getting Fiscally Fit.
Plugging in all of those numbers, what do we get? We get the Required Amount and the Reduced Amount. The required amount ($161,480.26) is what you would need annually if you wanted to buy the same goods and services that were purchased 20 years previously. In short, if you desire an annual retirement income of $100,000 – and you’re measuring in today’s dollars – you will need $161,480.26 in 20 years to retain the same value.
Of course, the reduced amount is just the opposite. The value (purchasing power) of that $100,000 in 20 years will only be $61,927.07.
Figure 2 – Inflation on a Larger Scale
Unfortunately, too many people fail to account for inflation or underestimate the impact it will have on their retirement plans. Even at relatively low rates, inflation is a real thief of buying power over time. The longer the time period, the more significant the impact. During your planning, you must account for inflation.