Planning for retirement is difficult enough without having to worry about inflation. There is a lot to consider when you stop working a regular job. Do you plan on living where you are now. Do you want a change of scenery? Would you prefer a place with less maintenance or a place where you can have a big garden or a workshop where you can build things?
There of course the financial aspects to consider as well. Will your retirement savings be adequate to provide the type of lifestyle you desire? There are a variety of Retirement Planning Calculators that can help you try to figure out how much you will need to save to have a happy retirement. You need to estimate your expenses once you are no longer commuting to work. So some experts use a rule of thumb that you will spend 20% less in retirement than you spend during your working years.
But suppose you want to travel more, or play more golf? Won’t that actually add to your expenses? And what about additional medical expenses. Isn’t it reasonable to assume that you will need more medical care as you get older? In addition to all these variables there is inflation. At the moment, inflation is moderate, but what if inflation heats up? What effect will that have on your retirement? Unfortunately, adding inflation into the retirement equation is like adding a moving target to a shooting range, it makes things much more difficult.
Why Inflation Makes Retirement a Moving Target
Let’s assume that you will actually spend about the same in retirement as you are currently spending because you will participate in more leisure activities. And let’s further assume that you are currently spending $50,000 /yr. if that was all there was to it all you would need to know was what age you planned to retire at and how long you would live after retirement. I know that is a big question. But according to the world bank the average life expectancy in 2010 was 78.2 years. So assuming that you retire at the age of 65 you need to provide for 13.2 years of retirement. At $50,000/ yr. That means that you need to have 13.2 x $50,000 or $660,000. not counting Social Security.
But if you add in the effects of inflation on retirement all that changes.
First you need to estimate the inflation rate between now and the time you retire. So assuming you are 50 now that would be 15 years. If inflation is 3% per year that means that next year your expenses would be $50,000 + ($50,000 x 3%) = $51,500 and the year after that it would be $51,500 + ($51,500 x 3%) = $53,045 and so on up until your retirement 15 years from now when you will require $77898 to buy the same things that you can buy today for $50,000. And that is if you know that inflation will be 3% per year. Which you don’t… it is a good long term average but during any given 15 year period it could be higher or it could be lower. This retirement planning calculator can help you play with these numbers and get a good feel for what you will need several years from now based on various inflation rates.
The next problem is that inflation doesn’t stop when you retire, so in addition to needing enough income to cover the $77,898 /yr. that amount will continue to increase by the inflation rate as well. So assuming that you wanted to have a nest egg large enough to throw off $77,898, fifteen years from now and you figured you could earn 10% per year (an optimistic projection these days) you would need to have accumulated $778,980. Thus it would generate $778,980 x 10% = $77,898. But wait, what about inflation? In addition to the 10% your nest egg would have to generate an additional 3% to cover the inflation and enough to cover the taxes on the $77,898 plus the taxes on the imaginary gain to cover the inflation. Whew, and that’s not even taking into consideration things like what happens if you live longer than the average?
Now you see why estimating how much you will need during retirement is so complicated especially when inflation is factored into the calculation. Because there are so many variables, in reality the best you can do is estimate how much you will need and then add as healthy a cushion to that as possible. The one thing on the plus side is that so far we have assumed that you haven’t touched your nest egg. It is possible at some point, to dip into your nest egg to some extent as you get older (of course the income it generates will decline as well). This will affect the amount available for your heirs however. But that issue can be addressed through life insurance. You might also consider an annuity as part of your retirement plan, which can guarantee you a certain fixed amount per month for the rest of your life, no matter what the investment climate is.
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