Realistic Rate of Return – Part IV Inflation

Realistic Rate of Return – Part IV Inflation

This is the fourth post in a series of posts on Realistic Rate of Return. You can view Part I, Part II, and Part III here. In this part I will try to touch on inflation and how it can affect my nest egg’s value as we travel through time. Sorry for the small delay between Part III and Part IV as this post has been sitting in my drafts folder 60% done for oh the last 9 months πŸ˜‰

What got me going was that I it was pointed out that I did not consider taxes and inflation in posts like this. While the original post was suppose to be more motivational than scientific it did bring up a good point that I have not talked too much about taxes and inflation on my blog and what do you know I had an article on inflation half done in my drafts folder so here you go.

When it comes to inflation I don’t think many people pay a whole lot of attention to it when doing their retirement planning and I think just how powerful inflation can be is often misunderstood. I think at a high level we all understand inflation, basically the cost of things keep going up. We here our parents or grandparents talking about buying soda and an ice cream for a nickel, or purchasing their first car for a few hundred dollars or maybe purchasing their first house for $10,000-$15,000. To some people this may seem like a fairly land world where everything could be bought on the cheap. The problem is while things didn’t cost that much in comparison to what they cost today, people 40 or 50 years ago didn’t make much money either. The average income in 1960 was $5,600 per year.

Now looking around PF Blog land a common number that I see that for people’s retirement goal is about $2.5 million dollars. That’s a whole lot of money!! A 4% withdrawal rate on $2.5 million is $100,000. So looking at $100,000 a year I sure would think that would be enough money each year for me to retire and live happily on.

Now let’s take a little trip back to the 1960s and find some young lad who happens to be in his 20s just like me. What would his goal for retirement be? Well to figure this out I am going to rely on this website. One thing to note in the table below is that household income has actually outpaced inflation over the last 45 years, which I think means that the average household has more purchasing power today than they did in 1960

Year Average household income Retirement Goal Number of times household income retirement goal is
2005 $46,326 $2,500,000 53.97
1960 $5,600 $394,512 70.44

So to keep things proportional with today’s $2.5 million goal, that young lad would should have a goal of just under $400,000 written down as a retirement goal in his diary. $400,000 is just as large in 1960 as $2,500,000 is today.

Now jump back to today and that young lad is now right at retirement age and let’s say everything went as planned and he saved up his $400,000 dollars. What kind of retirement can you have on $400,000 today? Not a very good one, or at least not the luxurious one that Mr. 1960 had envisioned. What happened? The answer inflation.

Assuming the same rate of inflation what will be the average salary and average retirement goal 30 years down the road? Believe it or not the average income in 2035 if everything went the same as it did for the last 45 years would be $195,704!! Mr twenty year old 2035 would be coming up with a retirement goal of $10,562,181. Yowsers!!

So what does this mean about your retirement nestegg? Well it means you need to factor in the effect inflation will have on your portfolio or you will be sorely disappointed with your results.

For Part V of this series I plan to talk about what you need to do to factor in inflation into your retirement plan, what rates to use, and how to protect your nestegg against inflation. In other words I need to learn a lot before I right this next post πŸ˜‰

  • Inflation can really play havoc with longer term financial plans – even at realtively low official rates like 2 or 3% (assuming the official rates represent the true rate of inflation which I doubt).

    Great way of illustrating the point. US$2.5 million may sound like a huge amount of money today, but it may well be insufficient by the time retirement arrives.

  • mathdude

    Another thing to consider is that although the arithmetic mean annual return is usually calculated as “expected return”, the correct calculation is really the geometric mean. For example, if one year your returns were 15% and the next year your returns were 1%, the expected return as normally calculated is 8% or 1.08, but the real expected return is sqrt(1.15*1.01) =1.0777 or 7.77%. This may seem insignificant, but the arithmetic mean is ALWAYS smaller than the geometric mean, and from 1965 to 2006, the average annual return was 1.090788 but the geometric mean of the annual returns is 1.080915. This may seem insignificant, but $1 invested in 1950 in the S&P would be about $84, but the calculation based on “average annual return” would be $141 … a 67% overshoot.

    As an exercise, take the annual returns over any period of time, and calculate normally the amount of money you’d make (i.e. rate^(#years). Now, divide the real end price by the real start price and see the difference.

Comments are closed.