Author Topic: How are you calculating your FIRE Number accounting for inflation and returns  (Read 1347 times)

joe189man

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i created a spreadsheet to model how much money i think i might need to retire and how long the stash will last. However inflation and its effect on retirement income/spending along with what interest rate to use for portfolio growth is throwing me off and causing confusion.

Here is what i did, i assumed a monthly spend rate for retirement in today's dollars (what i would want to spend if i was retired today) and applied inflation to that number until i reach my retire date (this increases the amount of the stash required). i also applied a tax rate to the spending (amount i would take out of stash each year), which further increases the stash size. Once a retirement age/stash size is picked, i continue to increase the spend rate in retirement according to inflation.

For example, $5k in monthly spending in today's dollars increases to $6,400 dollars in 10 years at 2.5% inflation. assuming a tax rate of 25%, the $6,400 turns into $8533 per month in withdrawals from pre tax at time of retirement. The $8533 spend rate per month would continue to increase annually in retirement at 2.5% inflation rate. In 20 years that after pre tax monthly withdrawals jump to ~$10,920 a month.

it seems silly to think in terms of "If I spend $40k a year in retirement then i need a $1 Million dollar nest egg" is that today's dollars? are taxes included or necessary there?

This is all hypothetical to help get an idea on the stash size required to retire and how long it will last.

Question 2

the rate of return assumed for stash growth, how do i not double count inflation? Can i use a 9% estimated annual return on stocks or do i need to adjust to about 6.5% to account for inflation.

i saw on one of the firecalc simulators that a return of about 6.3% was conservative but yielded a 75% success rate for the amounts and time horizons i was looking at, but wasn't sure.

any help or suggestions would be great

i can post my spreadsheet if anyone wants to see it, just let me know

MDM

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Doing everything in "real" dollars (i.e., assuming no inflation - neither for expenses nor as part of investment returns) is usually easiest to comprehend.

Yes, taxes are expenses when one is discussing safe withdrawal rates.

See
http://www.retailinvestor.org/pdf/Bengen1.pdf
http://www.aaii.com/files/pdf/6794_retirement-savings-choosing-a-withdrawal-rate-that-is-sustainable.pdf
https://www.bogleheads.org/wiki/Trinity_study_update
https://www.bogleheads.org/wiki/Safe_withdrawal_rates
for some reading.

BicycleB

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Like MDM, usually I just use adjusted-for-inflation numbers for everything.

For example:
625k stash
4% withdrawal rate
25k income
  1k taxes
___
24k spendable income

The above is close to my real numbers (FIREd a few years now) except that my details are more complicated.

Re inflation, my original estimate of spendable income was about $22,500 at the start of 2015 (though I didn't say it that way due to the details). Since then, inflation has been about 8% if I have calculated correctly. I can determine my current spendable income by adding 8% to the original figure:

22,500 original
  1,800 inflation effect (22,500 x .08)
--------
24,300 current spendable income

In the above example, I originally used the 4% rate of return because that is a typical rule of thumb that is reasonably robust for calculating FIRE withdrawals.

https://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

There are many portfolios that deliver returns of slightly more than that under most circumstances. You can read up on some them at portfoliocharts.com but for FIRE, I most often just use the 4% in projecting long term returns on financial assets. However, as implied in my main example, I don't plan to adjust spending based on return variances; I just seek to use my planned spending as a guideline for deciding among life choices.

SwordGuy

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Gosh, but you're doing it the hard way.

I'll give you an example.

We have 4 income streams:

1) Social Security
2) Rental House Income.
3) Rental Farm Income.
4) Stock and Bond dividends, interest and appreciation.

Our expenses include:

5) A fixed rate mortgage.
6) Food, clothing, insurance, transportation, etc.

Now let's look at inflation and its effect on those:


1) Social Security  -- includes cost of living adjustment (COLA).
2) Rental House Income - adjusts with COLA but lags a year or two behind.
3) Rental Farm Income - adjusts with COLA but lags a year or two behind.
4) Stock and Bond Index Fund dividends, interest and appreciation - I just subtract out average inflation from it's historically average earnings.

Our expenses include:

1) A fixed rate mortgage -- Doesn't change with inflation. :)
2) Food, clothing, insurance, transportation, etc. -- adjusts with inflation.

So, 2 of my 4 income streams keep up with inflation and the other two slightly lag it.   One of my bigger expenses does not increase with inflation and goes away in 12 years, freeing up additional income.   I pretty much assume they will cancel each other out and I factored in a slightly lower withdrawal rate in case I'm a bit wrong.

In other words, I really don't do anything near as hard as you're doing. :)

Travis

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The 4% rule accounts for inflation with the assumption that your portfolio will continue to grow during retirement at least at the rate of inflation. If it didn't, then your money would run out after 25 years.  I believe their formulas assume a 7% average growth in investments: 4% consumed, 2% inflation, and 1% of just growth.

You should absolutely plan on your taxes being an expense captured in that portfolio goal.

joe189man

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Thanks for the replies,

i checked my spreadsheet with the recommendations here and interestingly enough the retirement target ages are roughly the same when i work in today's dollars and comparing that with trying to account for inflation

BicycleB

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Well done, @joe189man!

FIRE 20/20

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The 4% rule accounts for inflation with the assumption that your portfolio will continue to grow during retirement at least at the rate of inflation. If it didn't, then your money would run out after 25 years.  I believe their formulas assume a 7% average growth in investments: 4% consumed, 2% inflation, and 1% of just growth.

You should absolutely plan on your taxes being an expense captured in that portfolio goal.

The origin of the 4% rule doesn't have any formulas that assume a 7% return or consumed/inflation/growth.  It looks at historical results if we assume someone started to withdraw varying percentages of their income and varying asset allocations.  For instance, if someone started to withdraw 4% at 75/25 stocks/bonds in 1917 and adjusted for inflation, would they still have anything left in 15 years?  20 years?  25 years?  30 years?  etc.  The people doing the study then iterated over varying stock/bond ratios, varying durations, and varying start years.  No assumptions were made for investment growth, inflation, etc. because that's already contained in the data.  MMM confused the issue, I think, when he wrote one of his 4% articles. 

DadJokes

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My spreadsheet uses projected nominal returns of 9% and expected inflation of 2%. That makes it easier for me to see if my returns and expenses match projections.

Travis

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The 4% rule accounts for inflation with the assumption that your portfolio will continue to grow during retirement at least at the rate of inflation. If it didn't, then your money would run out after 25 years.  I believe their formulas assume a 7% average growth in investments: 4% consumed, 2% inflation, and 1% of just growth.

You should absolutely plan on your taxes being an expense captured in that portfolio goal.

The origin of the 4% rule doesn't have any formulas that assume a 7% return or consumed/inflation/growth.  It looks at historical results if we assume someone started to withdraw varying percentages of their income and varying asset allocations.  For instance, if someone started to withdraw 4% at 75/25 stocks/bonds in 1917 and adjusted for inflation, would they still have anything left in 15 years?  20 years?  25 years?  30 years?  etc.  The people doing the study then iterated over varying stock/bond ratios, varying durations, and varying start years.  No assumptions were made for investment growth, inflation, etc. because that's already contained in the data.  MMM confused the issue, I think, when he wrote one of his 4% articles.

Don't blame him, that's me playing fast and loose with terminology.  Concur that all of their work is based on a century of hard data and some math.  The rest of us are making assumptions for the future based on their work.

ChpBstrd

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I think the OP discovered a key assumption with FIRE: That investment returns must exceed inflation rates. When that is untrue, the portfolio’s purchasing power is shrinking even before anything is withdrawn. Likewise, the portfolio only maintains purchasing power when withdrawals + inflation < ROI.

In theory, your equities keep up in the long run by repricing to account for higher input costs while maintaining steady margins. In reality, the 1970s were brutal years for stocks. Bonds are even riskier, from an inflation perspective, because you have a locked in low ROI and unknown future inflation. I think long-term bonds are potentially toxic, particularly at today’s low rates.

PathtoFIRE

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One comment about taxes. We don't even pay 25% of our large incomes in federal taxes (in TX, so no state tax). I think you may be significantly overestimating the taxes that you'll need to pay at FIRE. With long term capital gains/qualified dividends tax rate of 0% up to the 40k/80k single/MFJ, and with a standard deduction of 24k helping to cover short term gains, non-qualified dividends, interest, earned income, I would expect anyone withdrawing under 100k/year to have little to no federal tax.

joe189man

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you have a good point about taxes, just being conservative there.

My purpose for posting was to see how others are accounting for inflation. its hard (at least for me) to visualize thinking in today's dollars and using an inflation adjusted rate of return on a portfolio and not missing something, hence my complicated spreadsheet.

actual rates of return you see on 401k statements will not be inflation adjusted hence my concern for that method. i checked using inflation in returns and spending and working in today's dollars and both methods are roughly the same as far as a FIRE year.

i think i will keep inflation adjustments moving forward so i can understand the buying power of my stash.

the notes about real estate or other investments are noted for being inflation "proof" and likely will be part of our overall strategy
thanks again

SwordGuy

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My purpose for posting was to see how others are accounting for inflation. its hard (at least for me) to visualize thinking in today's dollars and using an inflation adjusted rate of return on a portfolio and not missing something, hence my complicated spreadsheet.



i think i will keep inflation adjustments moving forward so i can understand the buying power of my stash.


I still think you're making it harder on yourself.   Make your adjustments so things are in current dollars.  That way, all the calculation results you look at are actually meaningful.   You know what you should be able to buy for $10,000 today.   

ChpBstrd

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IDK, I also did an inflation adjusted spreadsheet and I don't think it was that complicated. For example, if cell A1 is spending in your first year of retirement, and A2 is your spending in the second, just drag down a formula that is "=A1*(1+inflation*)

*insert the cell you put the inflation % in here.

You do likewise for your investment returns. Your assumed ROI plus one is multiplied by each previous period's amount, after living expenses are withdrawn. This is compound inflation and compound interest visualized as you withdraw from the portfolio. That's as straightforward as it gets i think.

Advantages of the inflation adjusted approach include:
1) Ability to try out different inflation scenarios by changing a percentage in a single cell.
2) Ability to estimate the impact of post-FIRE big expenses, such as buying a house, going on a 4 month vacation, or doing a remod, all at their estimated future prices.
3) Ability to see how sensitive the fixed-income portion of your portfolio is to different inflation scenarios. E.g. you have 20% of your portfolio in treasuries yielding 2%, does it work when inflation hits 4%?
4) Comprehending the massive impact of inflation. Just think, the most frugal people in LCOL areas will be spending over $100k/year 30 years from now!

Disadvantages include:
1) Being intimidated by the crazy cost of living in nominal terms 30-40 years in the future.

ysette9

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Why are you making this so hard on yourself? Just use cFIREsim to model everything for you in way more precision than your spreadsheet I likely to have. You can just click boxes to check whether an income stream is indexed to inflation or not, and indicate how you want your expenses to be modeled (fixed, adjust with inflation, be flexible according to market conditions).