Many of us diligently put our salary deferrals or pre-tax contributions into our 401(k) or IRA accounts every year. It is our hope (and typically our mistaken illusion) that our retirement funds will allow us to quit working when are ready to retire. We calculate our savings rates and what we expect to earn in interest. We then sleep like babies, confident that our investments will produce at the rate we expect.
What many of us forget is that the general point of saving money for retirement is to use that money, or its interest, to maintain our lifestyles once we stop working. Yet even though our financial advisors know that we intend to use that money one day, we rarely hear about inflation.
Why is inflation important? Inflation determines what we can actually buy with the money we’ve saved. After all, since the point is to use the money to buy something at some point, it is important to know what we will be able to buy.
We ran some numbers to judge the effects of inflation on a mock investor. Peter is a 30-year-old executive who makes $100,000 per year. He is a good manager who expects to receive an annual 3.5 percent cost-of-living increase in his compensation. Peter wants to set himself up to maintain a good lifestyle in the future, so he decides to put 10 percent of his earnings into a 401(k) account each year.
If Peter averages an 8 percent return per year, he will have more than $1,600,000 in his retirement account by the time he is 60. Peter feels good about that number because he figures at that point, with the kids out of the house and a reduced lifestyle, he can significantly reduce his personal overhead. After all, an 8 percent return on $1,600,000 is more than $100,000 in interest alone. Looking from the lens of 2014, this number sounds good. However, Peter has yet to factor in his hidden tax, the tax of inflation.
The average annual inflation rate over the past 100 years is approximately 3.25 percent. If we factor a consistent 3.25 percent annual inflation rate to Peter’s retirement funds, we discover that his $1,600,000 will be worth a little over $600,000 in today's dollars. If Peter wanted to maintain his current lifestyle, his retirement money wouldn't last nearly long enough. Peter has essentially paid a 63 percent tax to inflation. On top of that, his 401(k) is a tax-deferred account. Every dollar of the $600,000 he distributes will cost him in taxes to the federal government.
The problem here is one of perception. There are two ways that Peter can look at his retirement investing plan and account for inflation:
1) Discount the return rate. With a 3.25 percent inflation rate, his 8 percent return is really more like 4.75 percent.
2) Inflation 10 years 20 years 30 years
1% 9% 18% 26%
2% 18% 33% 45%
3% 26% 45% 59%
4% 32% 54% 69%
5% 39% 62% 77%
6% 44% 69% 83%
7% 49% 74% 87%
When a financial planner or insurance agent starts talking about how much money you will have in 10, 20 or 30 years, make sure they account for inflation. Or calculate inflation’s effects yourself by subtracting 3 to 4 percent from the growth rate they estimate. That should give you an idea of the actual purchasing power that money will have when it’s available for use.