Author Topic: Accounting for inflation before retirement  (Read 5307 times)

rj83

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Accounting for inflation before retirement
« on: May 16, 2013, 11:39:51 AM »
Hi everybody,

I'm hoping someone can help me with a question about accounting for inflation.  I'm not sure if I'm looking at this right or not:

Ok, so I like playing with numbers, and decided to try to estimate how much I need to retire in 10 years (2023).  If I currently live on $20,000/year and assume withdrawal rate of 4% (http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/), then I will need $500,000 by year 2023. [$20,000/0.04 = $500,000]

I know the 4% withdrawal rate is considered "safe" because it accounts for 3% inflation (assuming 7-8% interest), but what about accounting for inflation in the next 10 years?  I'm living on $20,000 now, but in 10 years, due to inflation, maybe I'll need  $27,000 (based on 3% inflation/year).  In that case, savings needs to be closer to $675,000.  [$20,000 x (1.03)^10 = $26,878] and [$27,000/0.04 = $675,000]

My question, then, is should I be using the $20,000 or $27,000 value to estimate the amount needed in 10 years?

Thanks for your help!

NumberCruncher

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Re: Accounting for inflation before retirement
« Reply #1 on: May 16, 2013, 11:47:33 AM »
Doing it that way, you'd use the 27k figure for living expenses.

I like to think about it more in current $$ because it makes more sense to me.

In that case you would say "to retire now, I'd need 500k dollars," then you can use that as your goal and an inflation-adjusted rate of return on investments to determine when you might expect to reach FI  (tons of great calculators for this, btw)

matchewed

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Re: Accounting for inflation before retirement
« Reply #2 on: May 16, 2013, 12:25:03 PM »
Inflation IMO is best to be treated as an all or nothing. Either do all your calculations with inflation included or do them all with it not included. But you will always have to keep in mind that if you calculate a 500k goal without inflation included that your goal is not "really" 500k (just like you've already determined). I also adjust for inflation because it is easier for me to see if I'm on track. Plus during my earning years inflation is less of a threat. When you're FIRE inflation is a big threat and it is best to understand your personal CPI in a way, understand how expensive things are getting for you.

Also like all calculations it is just a best guess. Inflation might go crazy, it might not, we might hit a deflationary period, we might not. This is not to dissuade you from playing with inflation calculations as I think it is a very important concept to understand.

arebelspy

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Re: Accounting for inflation before retirement
« Reply #3 on: May 16, 2013, 12:28:05 PM »
Doesn't matter, as long as you're consistent.

I'd learn towards using inflation in both numbers (expenses and stache needed) though.

If you are calculating a number based on expenses in today's dollars, and your FI number is also in today's dollars, you're fine.  It just doesn't give you a target to shoot for.

Instead take a guess on inflation, inflate both numbers along with your expected return (above inflation, hopefully) and shoot for that number.

Then tweak as you approach it and the future dollars are worth today's dollars, because today is the future (whoah).
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mpbaker22

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Re: Accounting for inflation before retirement
« Reply #4 on: May 16, 2013, 12:33:14 PM »
I don't account for inflation between now and retirement.  But I have a reason for doing so, and I believe that's key.
The reason is that my expenses will go up with inflation, but my raises, unless I switch jobs or get promoted, will also match inflation, so I'll be saving about the same percentage.  So, I leave everything prior to retirement in today's dollars and let the 4% take over at that time.

arebelspy

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Re: Accounting for inflation before retirement
« Reply #5 on: May 16, 2013, 02:31:01 PM »
I don't account for inflation between now and retirement.  But I have a reason for doing so, and I believe that's key.
The reason is that my expenses will go up with inflation, but my raises, unless I switch jobs or get promoted, will also match inflation, so I'll be saving about the same percentage.  So, I leave everything prior to retirement in today's dollars and let the 4% take over at that time.

That's a perfectly fine way to do it, as long as you realize "the number" you're shooting for is too low, and you'll have to shoot for a higher number due to inflation.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

rj83

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Re: Accounting for inflation before retirement
« Reply #6 on: May 16, 2013, 03:20:04 PM »
Thanks for the replies, everyone! It's good to have confirmation that I'm looking at this the right way.  My goal is to be as conservative as I can (recognizing that it's all just an estimate), and then update the numbers as I get closer. 

Nords

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Re: Accounting for inflation before retirement
« Reply #7 on: May 16, 2013, 06:06:20 PM »
The reason is that my expenses will go up with inflation...
That's what the CPI claims, but our personal experience has been that some expenses go up while others go down. 

For example, here are a few changes that I would not have predicted a decade ago:
My daily calories have dropped during my 40s, and I'm eating 30% less than I was in my 30s. 
I've stopped drinking soda and alcohol, which drops another expense out of the grocery budget. 
Our teenager moved out, which cut our food bill nearly in half.  (I would've thought 33%... but 45%?!?)
Photovoltaic costs have dropped precipitously in the last five years, and our electric bill is under $30/month.
Our sewage bill is rising by 75% over a five-year period to replace the infrastructure.  It's now nearly 4x our water bill. 
Travel/vacation expenses have gone way down because we do it differently.
Furniture expenses have cratered (Craigslist).
Our insurance expenses have dropped (no more personal property coverage).
Replacement electronics.  A decade ago we owned seven VCRs and a five-CD carousel player.  Today CRT TVs are free at every neighborhood curb.
Home maintenance/repair expense have dropped.  We have the time to DIY and "fix it right".

Note that I was already retired before any of these changes happened. 

Done by Forty

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Re: Accounting for inflation before retirement
« Reply #8 on: May 17, 2013, 12:05:47 AM »
Then tweak as you approach it and the future dollars are worth today's dollars, because today is the future (whoah).

Ha!

mpbaker22

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Re: Accounting for inflation before retirement
« Reply #9 on: May 17, 2013, 11:15:51 AM »
To Nords and Arebelspy - Yes, I realize both points.  It's also easier to just save money and realize when you can live on 4% in my opinion.

The bigger issue for me to watch for is the added expense of a family that I do not currently have.  Until that's settled, I'm not planning on calculating a true number.

Nords

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Re: Accounting for inflation before retirement
« Reply #10 on: May 19, 2013, 08:54:57 PM »
The bigger issue for me to watch for is the added expense of a family that I do not currently have.
You'll have to let us know how to tell when the final buzzer has sounded on that game...