Spending Power

[OneDollarAtATime]

I've enjoyed reading through the forums and using other's FI goals, net worth goals, saving rates, etc. to stay motivated.

But...one question keeps coming to mind.

When I read all these 'retire in 2045 with $750,000' stories, is anyone considering the impact of their spending power as well?  Obviously, milk likely won't be $2 and gas won't be $3 per gallon in 2045. 

Lots of topics on here have to do with income and budgeting but I'm not sure I've seen much on future spending power.  I'd be interested in getting some insight from those who do consider this piece of the future and how they use it to plan for their FIRE goals.

[EricP]

Most people just keep all dollars in Current Year dollars and use real returns (usually 6%-7%) when calculating their growth instead of nominal returns which would be higher.

[BarkyardBQ]

7% average market growth

3% average yearly inflation

4% safe withdrawal rate

Spending power is built into the formula.

If you retire and need $25,000 to live in year 1, then in year 2 you withdrawal $25,750.

You should be looking at your current spending and estimate a 3% yearly inflation up to the point where you FIRE
and/or
You will need 25*COL from the year you FIRE and then your portfolio is inflation adjusted for the future.

https://en.wikipedia.org/wiki/Trinity_study

[Eric]

We just use current dollars because it's easier.  All withdrawal plans (should) include inflation adjustments to maintain standard of living.   So if your plan is say $40K/yr, it's understood that this means $40k in year one only, then $40k * inflation (say 3%, or $41,200) in year 2, etc.

[Eric]

7% average market growth

3% average yearly inflation

4% safe withdrawal rate

Spending power is built into the formula.

If you retire and need $25,000 to live in year 1, then in year 2 you withdrawal $25,750.

Is 3% the average yearly inflation?  Does that include the 70s?  I definitely wouldn't plan for a static number.

[Eric]

Obviously, milk likely won't be $2 ... in 2045. 

Some people pay 7.5x that much already! :)

http://forum.mrmoneymustache.com/antimustachian-wall-of-shame-and-comedy/a-gallon-of-milk/

[BarkyardBQ]

7% average market growth

3% average yearly inflation

4% safe withdrawal rate

Spending power is built into the formula.

If you retire and need $25,000 to live in year 1, then in year 2 you withdrawal $25,750.

Is 3% the average yearly inflation?  Does that include the 70s?  I definitely wouldn't plan for a static number.

Yes Eric, average includes the 70s, because to be an average you have to include all samples. It therefore must also include the last decade where it's been less than 3%.

http://www.usinflationcalculator.com/inflation/historical-inflation-rates/

[Eric]

7% average market growth

3% average yearly inflation

4% safe withdrawal rate

Spending power is built into the formula.

If you retire and need $25,000 to live in year 1, then in year 2 you withdrawal $25,750.

Is 3% the average yearly inflation?  Does that include the 70s?  I definitely wouldn't plan for a static number.

Yes Eric, average includes the 70s, because to be an average you have to include all samples. It therefore must also include the last decade where it's been less than 3%.

http://www.usinflationcalculator.com/inflation/historical-inflation-rates/

Thanks for the snarky reply!  I wish your link actually backed up that number, but I guess I can do my own searching.  However, the actual number isn't really all that important.  The point of my post was that it doesn't do much good to plan for average, especially at 3%, because if we go through another decade like the 70s and you've only planned for 3%, you're gonna have a bad time.

[atrex]

It seems to me that people seem a little too certain about stock returns and inflation rates so I think it is a valid question.  Right now, I think we're looking like we're more in a deflationary situation... the fed can hardly move the interest rate even though we're probably near the end of a credit cycle.  So 70s inflation seems unlikely, but that's only for the near term. 

[lostamonkey]

The "4% rule" is based on retirement years which include world wars, depressions, recessions, and major inflation. Given this circumstances, withdrawing 4% in year 1 and adjusting your future year withdrawls based on the inflation rate has worked a very high percentage of the time. So unless you think the future is going to be significantly worse than the past, the 4% rule is fairly safe.

[galliver]

MMM has a post titled something like "Enough...and a little extra" that I think is relevant. Main tenets being, IIRC, that most likely your retirement budget isn't completely bare -bones and there's something to cut, that you can go back to work at least during the earlier part of that, that you'll possibly/likely end up with a marketable hobby, and that any buffer or extra earnings you have will end up growing if you don't touch them, giving you a bigger cash cushion later.

[pucksr]

7% average market growth

3% average yearly inflation

4% safe withdrawal rate

Spending power is built into the formula.

If you retire and need $25,000 to live in year 1, then in year 2 you withdrawal $25,750.

Is 3% the average yearly inflation?  Does that include the 70s?  I definitely wouldn't plan for a static number.

Yes Eric, average includes the 70s, because to be an average you have to include all samples. It therefore must also include the last decade where it's been less than 3%.

http://www.usinflationcalculator.com/inflation/historical-inflation-rates/

Thanks for the snarky reply!  I wish your link actually backed up that number, but I guess I can do my own searching.  However, the actual number isn't really all that important.  The point of my post was that it doesn't do much good to plan for average, especially at 3%, because if we go through another decade like the 70s and you've only planned for 3%, you're gonna have a bad time.

What you are saying: Sure your car has averaged 25 mpg over the last 2 years, but isn't it silly to assume you will use 25 mpg over the next 3 months?

It would be silly, if you had to figure out exactly how much gas to put in your tank. Fortunately, you have some flexibility.

1) If you are wrong about your savings amount, it isn't as if you will suddenly be homeless. You have years to prepare.
2) high inflation generally impacts the market as well. While inflation was bad in the 70s, the market had double-digit annual returns in the second half of the decade.


Sent from my XT1049 using Tapatalk

[2lazy2retire]

MMM has a post titled something like "Enough...and a little extra" that I think is relevant. Main tenets being, IIRC, that most likely your retirement budget isn't completely bare -bones and there's something to cut, that you can go back to work at least during the earlier part of that, that you'll possibly/likely end up with a marketable hobby, and that any buffer or extra earnings you have will end up growing if you don't touch them, giving you a bigger cash cushion later.

All a bit wishy washy for me - 3% and done

[Eric]

The point of my post was that it doesn't do much good to plan for average, especially at 3%, because if we go through another decade like the 70s and you've only planned for 3%, you're gonna have a bad time.

What you are saying: Sure your car has averaged 25 mpg over the last 2 years, but isn't it silly to assume you will use 25 mpg over the next 3 months?

Either you misunderstood what I said, or you're the world's worst analogy writer.  I'll guess it's the former.  I'm saying that you need to be flexible.  Planning for 3% is going to leave you pretty unhappy if inflation is 8% for a decade.  Why plan for a static number at all?  Plan for the actual inflation rate instead.  This is how the Trinity Study (among others) do it for backtesting.  They don't just plug in a single number, they use the actual inflation rates.

If you want to use a car analogy, it would be more like asking "what kind of oil will you use in your car in 2045?"  Sure, your current car uses 5w30, but your 2045 car could use 0w20, 10w40, something in between, or even none at all.  It's better to plan to be adaptable to whatever oil the manufacturer recommends as opposed to buying a barrel of 5w30 thinking that all future cars will run well on it.

[pucksr]

Either you misunderstood what I said, or you're the world's worst analogy writer.  I'll guess it's the former.  I'm saying that you need to be flexible.  Planning for 3% is going to leave you pretty unhappy if inflation is 8% for a decade.  Why plan for a static number at all?  Plan for the actual inflation rate instead.  This is how the Trinity Study (among others) do it for backtesting.  They don't just plug in a single number, they use the actual inflation rates.

As quoted from the "Trinity Study":
"If history is any guide for the future, then withdrawal rates of 3% and 4% are extremely unlikely to exhaust any portfolio of stocks and bonds during any of the payout periods shown in Table 1. In those cases, portfolio success seems close to being assured."

Weird. It completely agrees with what everyone else is saying. Perhaps everyone came to the 4% number because of things such as backtesting and 'back-of-the-napkin' averages of inflation and stock returns.

https://en.wikipedia.org/wiki/Trinity_study

I wrote my previous response on my cellphone. I will try to write something here that is a bit more clear. "Using the averages" works because of a thing known as "regression towards the mean".
You posit the situation of the inflation rate being 8% for a decade. That would be unprecedented. We did have some really bad inflation in the 70s though.
http://www.multpl.com/inflation/table

Jan 1, 1983    3.71% Jan 1, 1982    8.39% Jan 1, 1981    11.83% Jan 1, 1980    13.91% Jan 1, 1979    9.28% Jan 1, 1978    6.84%

So, let us imagine you were retired during that period. You would have been screwed right?
If you had purchased an index fund of the S&P 500 on Jan 1, 1978 it would have cost you $95
On Jan 1, 1983, that same item would have inflated to $145.12  http://www.usinflationcalculator.com/
The value of that stock on Jan 1, 1983? $140.64
The market kept up with inflation pretty closely.
(It has to keep up. No one would invest money if they didn't think it would beat inflation. This is economics 101 and why the Fed is so concerned with controlling inflation rates)
So, imagine you were using the 4% rule.

Stock    Holding   Withdraw   New Balance Price 96.11     96.11       3.8444     92.2656 106.52   102.2592   4.2608   97.9984 136.34   125.4328   5.4536   119.9792 119.55   105.204   4.782   100.422 140.64   118.1376   5.6256   112.512

Well, looks like you only have about $112.51 of your original $95. That is the equivalent of about a 34.5% loss in purchasing power. During the highest rate of inflation in history.
I wonder what happens next? Imagine we keep your money in that account?
By 1987, you will have $157 in your account, only $10 less than inflation. You are also paying yourself 4% a year.
You paid yourself $9.86 in 1987, which is CONSIDERABLY more than you paid yourself in 1978($3.85 or $6.71 adjusted for inflation)

Let us think about this. You just weathered the highest inflation in US history. Your fixed income is now MORE lavish than you probably need and you still have plenty of money in the bank.
That is good. You could reduce your withdrawal to 3%. We are about to drop the economy off a cliff(Oct 1987), but your nest egg will recover from that too if you just behave patiently.

Conclusion
The only problem with the 4% rule is that you should really withdraw what you need. 4% is a good rule for determining the size of your retirement account. However, once you retire 4% will likely be an unrealistic number. If you would have adjusted your withdraw to 3% in my example you would have maintained the same purchasing power each year while growing a larger retirement account to prepare for some eventual stock market crash.

[Eric]

A simple, "I agree" would've sufficed, but I do appreciate the detail.  :)

[pucksr]

But I disagree.

Sent from my XT1049 using Tapatalk

[Eric]

But I disagree.

And I disagree with your disagreement.  Gee, this is fun!

Can't take yes for an answer, eh?  Here, I'll start.  I agree with everything you said.  I don't think there's a single contradiction between what you said and what I said.  Because of that, I think we're in agreement.  But hey, I like to argue as much as the next guy.  So why should we agree when we can disagree?  Go ahead and point out where you think the problem is so we can really get into not agreeing about the same thing.

[pucksr]

So you agree that 3% is a good assumption?

Sent from my XT1049 using Tapatalk

[Eric]

So you agree that 3% is a good assumption?

For what?  Future inflation rate?  Sure, it's possible, or even probable, that many years will see an inflation rate at or around 3%.  However, as mentioned above, planning for 3% every single year is simply lazy and has the chance to throw off your WR by leaving you overdrawn during times of low inflation or underdrawn during times of high inflation.  This seemed to be what you were also referencing by showing how withdrawal rates can fluctuate with inflation above.

If inflation is 1%, and you're withdrawing X * 1.03, you're drawing down faster than your prescribed WR.
If inflation is 6%, and you're withdrawing X * 1.03, you're drawing down slower than your prescribed WR.

If these inflation rates revert to the mean in a year or two, it's probably not a big deal.  But personally, I'd rather not guess at future inflation.  If a higher or lower inflation amount stretches on for a number of years (take your pick, 4, 6, 8, whatever), you can get pretty far out of whack by using a standard "average" number.

And again, all backtest scenarios (like the Trinity Study) use actual inflation numbers.  Simply plugging in a static number means that you're not following the methodology used and therefore your results are less likely to correlate with the past results that you're trying to measure against.

I think 3% is likely, but would never actually plan for only 3%.  Are you with me?

[pucksr]

Ok, this is where we disagree. I think that an assumption of a 3% inflation rate is perfectly acceptable IFF you are using it for any long-term planning.
Backtesting is stupid. In pretty much all financial scenarios, back-testing is a joke. Do you similarly bet on roulette at a casino based on how many times it has been black in a row in the past 10 spins?

See where we disagree?

Now, I also think your concern over inflation rate is pointless.
The long-term investment return rate > long-term inflation rate.
When people are assuming that they will have a 3% inflation and a 7% return on investment they might be wrong. It could be an 8% annual inflation and a 12% annual return. The two numbers are inter-related. You aren't likely to see the long-term investment-returns drop to 1% while inflation shoots up to 8%.

[Eric]

Backtesting is stupid. In pretty much all financial scenarios, back-testing is a joke.

So you've never run firecalc or cFIREsim to determine how your planned retirement would've fared in the past?  You're definitely an anomaly then.  I find them extremely helpful.

Now, I also think your concern over inflation rate is pointless.
The long-term investment return rate > long-term inflation rate.
When people are assuming that they will have a 3% inflation and a 7% return on investment they might be wrong. It could be an 8% annual inflation and a 12% annual return. The two numbers are inter-related. You aren't likely to see the long-term investment-returns drop to 1% while inflation shoots up to 8%.

Great, except that I don't have a concern over the actual inflation rate.  I have a concern over using a static inflation rate to determine the withdrawal amount from your portfolio.  Is this not clear?  I feel like this is the third time I've written it.  Let me try to rephrase to hopefully avoid a fourth time.

I am planning to use the actual inflation rate to determine the withdrawal amounts from my portfolio.  If you're giving yourself a 3% raise every year, then your spending power fluctuates.  If you're giving yourself an inflation adjusted raise every year, then your spending power remains constant.

If you're okay with the fluctuations, then have at it.  You're taking on more drawdown risk using a static number though.

[pucksr]

I would recommend the following reading: The Black Swan by Nassim Taleb
I would argue that you are probably better using truly random data points in your simulation. The past is an amazingly limited dataset and will probably never repeat.

As far as your point about "static inflation", I see where we have a misunderstanding.
Most people aren't giving themselves a 3% raise each year. They are using 3% for planning purposes.
"Planning future inflation" doesn't even make sense when you think about it. Each year you are going to give yourself a raise based on the previous year's inflation? Why?
Are you going to use CPI or CPI-U? Is home pricing a major concern for a retired person?

[brooklynguy]

Ok, this is where we disagree. I think that an assumption of a 3% inflation rate is perfectly acceptable IFF you are using it for any long-term planning.

For what "long-term planning" purpose are you projecting future inflation rates?  If it's for the purpose of determining annual drawdown amounts from your portfolio, as Eric said, it would be stupid to use a static figure derived from your projections instead of simply using actual inflation (i.e., the amount your expenses have actually risen).  If it's for some other purpose, please explain what that purpose is, because that's what's causing the disagreement.  What would you do differently if your projected future inflation rate were, say, 6% instead of 3%?

[pucksr]

7% average market growth

3% average yearly inflation

4% safe withdrawal rate

Spending power is built into the formula.

If you retire and need $25,000 to live in year 1, then in year 2 you withdrawal $25,750.

Is 3% the average yearly inflation?  Does that include the 70s?  I definitely wouldn't plan for a static number.

I think I see the confusion. I will bow out.
This really isn't worth explaining. Eric really wants to point out that actual inflation is important, which it is.
He also wants to use antiquated statistical methods of simulation, which I originally wanted to point out are somewhat useless. All that matters is the actual average.
We could consider the entire history of inflation as a "Monte Carlo" simulation. We could hypothetically have 30 years of 50% annual inflation.

[Eric]

He also wants to use antiquated statistical methods of simulation, which I originally wanted to point out are somewhat useless. All that matters is the actual average.
We could consider the entire history of inflation as a "Monte Carlo" simulation. We could hypothetically have 30 years of 50% annual inflation.

By all means, please go ahead and point out the current methods of simulation that would be more useful.

[acroy]

WSJ has an excellent retirement calculator. Best I have seen. It allows easy adjustments of future inflation, return on investments, etc. Enjoy.

http://www.marketwatch.com/retirement/tools/retirement-planning-calculator

[pucksr]

He also wants to use antiquated statistical methods of simulation, which I originally wanted to point out are somewhat useless. All that matters is the actual average.
We could consider the entire history of inflation as a "Monte Carlo" simulation. We could hypothetically have 30 years of 50% annual inflation.

By all means, please go ahead and point out the current methods of simulation that would be more useful.

I did. Monte Carlo

Sent from my XT1049 using Tapatalk

[deborah]

One of the problems with high inflation is that income tends to lag, so even if is averages the same, because it is lagging you can actually be in trouble. This is why many people lost their houses during the period of high inflation.

[GuitarStv]

I'm using the 4% rule as an idea of approximately what kind of income I'll have post retirement.  In retirement I don't plan to live so close to the margins that a few tough years and bad returns couldn't be handled by simply cutting back on non-essentials.  Beyond basic food, shelter, and water everything is non-essential.

Even in the worst case scenario, I could always take up a part time job to add more income.  I don't see any reason to be overly concerned about the 4% rule.