Inflation is an increase in the price of goods and services over time. If the price of goods and services go up, then your money will buy less. Since inflation will erode your wealth, it can delay your retirement.
When I say “goods and services”, I am referring to generic items, such as the phone bill or even your lunch.
Inflation is a natural part of the economy so we cannot avoid it. We can only understand and prepare for it. In many ways, it is similar to the concept of a recession. We cannot prevent it, but we can protect ourselves from a recession.
To understand inflation, we need to understand how our government measures the increase of prices. The official unit of measurement is the Consumer Price Index.
What is the Consumer Price Index?
The Consumer Price Index (CPI) is how the U.S Bureau of Labor Statistics measures the change in prices for goods and services paid by consumers. With the CPI, we can calculate inflation.
This chart is pulled directly from the U.S. Bureau of Labor Statistics and illustrates the year over year change of the CPI.
When there is a positive change in the CPI, it means inflation has occurred and the prices of goods and services has gone up. There is a formula for calculating inflation, but we don’t need to know it. There are plenty of free inflation calculators online.
Using the calculator, if my lunch cost $10.00 in 2010, the same lunch would cost $11.56 in 2018. In just 8 years, my same exact lunch has increased by 15.6%. Imagine if it was my cable bill, $100.00 would be $115.58.
The rising cost of goods and services hurts us. On average, the annual inflation rate from 1913 to 2013 has been 3.22%. Since this is an average, some years will be higher and some years will be lower than 3.22%.
The Term Inflation-Adjusted
I’m sure you hear the term inflation-adjusted here and there, especially when it comes to saving for retirement.
Inflation-adjusted means converting a dollar value from one year to a dollar value in another year. For example, $1 in 1950 is worth much more than $1 in 2018.
If I told you, I could live off $1 in 1950 for a whole week, what does that tell you? It is hard to say. We need to put this $1 in context and that is where inflation-adjusted comes into play.
In 2018’s dollars, $1 is actually worth $209.16. Just like how the cost of goods and services went up between 1950 to 2018, the same will happen between now and when we retire.
When we look at data, we always want the value of the dollar to be inflation-adjusted to the value of today’s dollar to provide context.
How does it Affect my Investments and Retirement?
Imagine saving $1,000,000 for retirement only to find out that instead of living comfortably for 30 years, you can only do so for 10 years, the reason being that the cost of goods and services went up.
When we aim for a total amount for our retirement savings, we need to consider inflation. The best way to do so is converting all numbers to today’s dollars.
Our yearly expenses in retirement because it is already in today’s dollars and there is no need to convert them.
When we calculate our return on investment, we need the average real rate of return to understand how fast our money grows. The average real rate of return, accounts for inflation and will calculate our investments in today’s dollars.
The average rate of return should not be used to calculate our investments because it does not account for inflation.
From 1950 - 2009, the average rate of return is 11% and the average real rate of return is 7%. This makes sense because inflation should reduce the value of our investments. The average real rate of return will be lower.
We want to always calculate our investment with 7%.
As long as we do not over-inflate the value of our investment projections, then we should be accounting for inflation.
For the most part, the content I share with everyone is adjusted for inflation in today’s dollars including my Simple Guide to Retirement for Young Professionals.
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