Summary

The article discusses the impact of inflation on long-term financial planning and retirement savings, emphasizing the importance of accounting for inflation to maintain purchasing power.

Abstract

The article, "How to Protect Your Long-Term Financial Plans from an Insidious Threat," underscores the often-overlooked danger of inflation in retirement planning. It illustrates the erosion of purchasing power over time using historical examples, such as the dramatic decrease in the real cost of a mortgage payment for the author's parents due to inflation. The piece argues that even modest inflation rates can significantly diminish the value of money, potentially reducing the purchasing power of a $1 million stash to less than$ 300,000 over 40 years. It criticizes financial experts and banks for frequently ignoring inflation in their projections, which could lead to retirees having far less spending power than anticipated. To counteract this threat, the author suggests a method for calculating a retirement budget that accounts for inflation, involving the "4% rule" and projecting future costs in today's dollars. The article concludes by stressing the necessity of incorporating realistic inflation assumptions into retirement planning to avoid underestimating future financial needs.

Opinions

The author believes that financial planners often fail to consider inflation in their retirement projections, which can be misleading for clients.
Inflation is portrayed as a silent threat that can drastically reduce the purchasing power of savings over time.
The author suggests that individuals can protect their retirement plans from inflation by using a specific calculation method that adjusts for expected inflation rates.
There is a skepticism about the ability of institutions like the Federal Reserve to manage inflation effectively.
The article implies that relying solely on historic stock market returns may not be sufficient without also considering the impact of inflation.
Social Security is acknowledged as a potential source of income that could mitigate the impact of inflation on retirement savings, albeit with some uncertainty regarding its future payouts.

How to Protect Your Long-Term Financial Plans from an Insidious Threat

The trap that gets even financial experts and banks

In the mid-1950s, my parents bought their first house using a fixed-rate 15-year mortgage. The payments were exorbitant, eating up almost half of my dad’s take-home pay. By the time they paid off the loan in the late 1960s, the same payment cost only as much as a nice dinner out for the family! How did that happen, and what can that “ancient history” teach you that can save your retirement plan?

The Insidious Effects of Inflation

If you’ve read much about retirement planning, you know that the earlier you start setting money aside and investing for retirement, the better. That’s because your investment returns compound over time. However, investment returns aren’t the only things that compound over time. Inflation does too, and not to our benefit.

How 40 years of inflation from 1978 to 2018 decimated the purchasing power of $1M.

As you can see above, if you took $1 million in 1978 and stashed it under a mattress, 40 years later that million would buy less than $300,000 worth of goods as measured in 1978 dollars. That’s an extraordinary loss of more than 70% of purchasing power over 40 years! What might shock you even more, inflation averaged just a bit over 3% per year over that 40-year period! That’s how insidious inflation can be.

But it could actually be much worse. Had you started that 40-year period just a decade earlier, in 1968, as seen below, you would have lost over 83% of your purchasing power!

How much worse the impact of 40 years of inflation was from 1968 to 2008.

Even the Experts and Banks Usually Don’t Get this Right

As my parents’ story demonstrates, their lender didn’t account for inflation in the terms of their loan. That’s how their payment went from almost half of a monthly salary to barely the cost of a restaurant meal for five.

Similarly, if you happened to take out a 30-year fixed mortgage around the summer of 2016, you might have scored an annual interest rate of under 3.5%. If inflation goes back to its long-term average, your inflation-adjusted interest could be nearly 0%, and the investors who bought your loan might actually lose money!

If you look at the pretty projections created by financial planners, almost none of them account for inflation. They’ll talk about how much you’ll set aside each year, how you’ll split investments between different asset classes, how much each asset class may return, etc. Then they’ll give you a wonderfully large number of dollars that you should reach by the time you’re ready to call it a career.

What they will rarely if ever mention, mostly because they don’t think about it, is that the $1M+ nest egg their plan projects for you will likely be worth pennies on the dollar by the time you’re ready to start spending it!

How to Beat Inflation with Your Personal Retirement Planning

Neither you nor I have any control over inflation (even the Fed has a hard time managing that!). The only thing we can do is account for it in our planning. If you expect to retire in 40 years, make a retirement budget in today’s dollars, but then multiply it by 1.03^X (that’s 1.03 to the power of X), where X is how many years you have before you retire. Finally, to get from this projected-inflation-corrected budget to your nest egg target, multiply it by 25 (per the famous “4% rule”).

For example, if your retirement budget is $50,000 in today’s dollars, you should plan on building a nest egg that’s 25 times that amount, or $1,250,000 in today’s dollars. However, if retirement is 40 years away and inflation averages about the same 3% as it did over the past century, you’d need $50,000 × 25 × 1.03^40 or just under $4.1M, counting in the dollars of the year you’ll retire.

That looks super daunting, doesn’t it? However, with the nominal historic return of the stock market at ~10% per year, investing just over $8000 a year in stocks (and increasing that contribution by the rate of inflation each year) for 40 years will get you there.

If you take into account that even with its problems, Social Security will probably pay out about 75% of your promised benefits, an inflation-adjusted $6000 annual retirement set-aside just might be enough to do the job.

The Bottom Line of Accounting for Inflation

If your retirement plan fails to account for inflation, you might think that you need a lot less than what you will actually need. This could completely derail your retirement, requiring you to drastically decrease your spending, or risk running out of money before you run out of lifetime.

If you pay a financial planner to help you craft a retirement plan, ask them what inflation numbers they’re assuming, and what you could realistically expect to spend in today’s dollars from the nest egg they project for you.

Disclaimer

This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

About the Author

Opher Ganel has set up several successful small businesses, including a consulting practice supporting NASA and government contractors. His most recent venture is a financial strategy service for independent professionals. You can connect with him there, or by following his Medium publication, Financial Strategy.