MM014: The Simple Math of Calculating Inflation in Retirement
Figuring out how to calculate how inflation affects your retirement savings is made out to be a super-complicated process, requiring advanced math skills. What's frustrating is that calculating how your retirement savings is impacted by inflation isn't all that difficult. In today's episode, we talk about the simple math of calculating inflation in retirement.
IN THIS WEEK'S EPISODE
* The over-complicated world of retirement calculators
* A look at historical data to gauge rates of return and inflation
* Introducing REAL rate of return
* We talk about fees...again
* How inflation works with the 4% rule
The Simple Math of Calculating Inflation in Retirement
Retirement calculations can be hard
If you want to do any sort of retirement or long-term personal finance planning, you’ll inevitably find yourself at an online calculator.
For figuring rates and assumptions, it can be easy to just go with whatever the online calculators spit out for an estimated rate of return, but without understanding the rate of return they assume, it can make a big difference.
For example, if they assume a rate of return of 7%, does it factor in inflation, or are they adding it in later? You should understand how they're accounting for inflation in the number that they spit out. The problem is, most calculators and advice out there is unnecessarily complicated.
Granted, I'm not a professional, and I may be giving you wrong information, so check with an expert first, but the math here is, and should be, simple.
Using historical data to create averages
Average rate of return from S&P; 500, which is a pretty diversified collection of 500 stocks, is about 10% since its inception in the 1920s. That's pretty good since there have been some big downturns during that time. If you held only the S&P; 500 in 2008, you would have lost 37% of our portfolio, but in the next two years, it returned almost 27% and just over 15%, giving it a pretty quick rebound. Now, you've got to take the long view on investment returns, especially when you're taking a more aggressive angle with an stock portfolio during your earning years.
But, let's stick with 10% return as an average. That doesn't factor in any inflation, which you can relatively safely estimate at 3%. Then, all you've got to do is takes the difference of your investment return and your inflation rate to find your real rate of return of 7%, which is your inflation-adjusted return. Simple.
How to use the real rate of return (RRoR)
Now, just plug your real rate of return number (based on your expected rate of return) into your retirement calculator of choice, and make sure they're spitting out non-inflation-adjusted numbers. Then, you can more easily plan in today's numbers for what you'll need in 20-30 years.
Watch for fees!
Vanguard S&P; 500 ETF, which matches the index, has an expense ratio of 0.04%, which is virtually nothing. Think, if you pay the average 1% management fee so you can MAYBE squeak out a little extra return, that’s like adding an extra 1% to the inflation rate. Or, conversely, it's like shaving an extra percent off your inflation rate. And it's not complicated to do. Just open up an account at vanguard.com and look for the ticker VOO. Then, just buy the number of shares your want just like you're ordering underwear and it's that easy to start investing.
How inflation impacts the 4% Rule
As we've discussed before, I'm a big fan in the 4% rule. It's not foolproof and it is a bit general in its advice, but it probably gets you most of the way to planning for your personal finance future. What's great, and often overlooked, is that the 4% rule already bakes in retirement by increasing the percentage each year due to cost-of-living adjustments, about 3%, I believe,