Question: I’m trying to understand how much I need to have saved for retirement to maintain my spending power. I’m concerned about inflation, which could erode how far my savings will go in the future. How can I account for this?
Answer: Accounting for inflation is an important aspect of financial planning. But lately, it has been a particularly hot topic. And there’s good reason for that. Inflation has been significantly elevated since 2021, reaching as high as 8% in 2022.
While inflation reduces your spending power and can erode your financial security it doesn’t necessarily have to. The key to beating inflation in retirement is to account for it and incorporate it into your plan.
[Related:How Retirees Can Cope with Inflation]
Expected vs. Unexpected Inflation
First, understand that inflation will always exist. Moderate and low levels of inflation, like Americans saw throughout the 2000s and 2010s, aren’t anything about which to be concerned.
Inflation does reduce your purchasing power, but you can beat it by simply projecting it into your plan.
It’s the unplanned inflation that hurts you.
[READ: Should You Stop Saving for Retirement Because of Inflation?]
Accounting for Inflation Projections in Retirement
For example, let’s say that you estimate that long-run inflation will be 3%, which is close to the historical average, and adjust your savings, return assumptions and expense projections accordingly. If inflation does average out to 3% over your time horizon, then all is well: You planned for it. But if during that time, inflation averages to 5%, you’ll only be hurt by the additional two percentage points you didn’t expect. That’s not great, but it’s very different from not planning for it at all.
You need to incorporate inflation expectations mathematically into your plan, or you are effectively ignoring it. It’s not just an idea or thought. Failing to include inflation in your retirement projections is the same as estimating it will be 0%, and any inflation will leave you worse off. Unfortunately, many people do this.
How to Incorporate Inflation Into Your Retirement Plan
There are a couple of different ways you can proactively work inflation expectations into your retirement plan.
Adjust Your Return Assumptions
Retirement savings are a significant component of retirement plans. Just like savers can’t predict what inflation will be, they can’t know how their investments will perform. So, investors can’t know exactly how much they will have saved once they retire.
This requires future retirees to use an estimate for their savings projections. Some use historical data, such as the S&P 500’s average of a little over 10%. The number you choose should be based on your own investment approach and risk tolerance. Whatever you decide to use, you can adjust it for inflation.
This is called your real rate of return, while the unadjusted estimate is called your nominal rate of return.
While the formula is slightly more complicated, there’s a convenient shorthand way of adjusting your return assumption for inflation that works for practical use. Simply subtract your expected inflation rate from your return assumption.
To see an example, assume that you expect to earn a nominal 8% return and that inflation will be 3%. The real rate of return would be 5%. Assume you plan to save $10,000 per year for the next 20 years.
— At 8% growth, you would have $457,620 nominal dollars in your account.
— Using the 5% real rate of return, those nominal dollars would be worth $330,660 in today’s value.
You can compare that $330,660 against your current expense estimates. This may be the better approach if you are young and still have many years until retirement.
Adjust Your Expense Estimates
You can also inflate your expenses by the rate you choose. You might do this by considering the amount you plan to spend in retirement based on your current estimates. Say that’s $5,000 per month in today’s dollars. If you expect inflation to be 3%, increase that amount by 3% for every year of retirement.
So, the next year you would need $5,150. The year after you would need $5,305 per month, and so on.
This approach may be better if you are closer to retirement or already retired because you have a good idea of what you’ll need to spend to maintain your desired lifestyle or cover your needs. Plus, it allows you to be more specific and inflate different expenses at their own rates. Some prices may increase more or less than others.
Do Not Combine These Approaches
As a caution, do not combine both approaches. You may switch between the two. But do not do them both at the same time. This will count inflation twice.
[Read: How to Handle Retirement With Rising Inflation]
Adjusting for Inflation in Retirement
Once you’ve worked inflation into your plan projections, you can see what changes you may need to make.
If you still seem to be on track after adjusting for inflation, you may not need to make any changes at all. If the adjustments reveal some weakness in your plan, you’ll want to work through how you plan to adjust. That could be saving more, working longer, or looking for ways to reduce your planned spending.
To have a successful retirement, it’s important to plan for it. Inflation is a component of your plan. You may not be able to escape it entirely, but you can beat it.
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Ask a Financial Pro: Inflation Seems to Be Eating Away at My Future Spending Power. How Do I Plan for Inflation in Retirement? originally appeared on usnews.com
