Author Topic: A common error when calculating your target amount  (Read 17253 times)

Bertram

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A common error when calculating your target amount
« on: November 24, 2015, 01:53:19 AM »
A common error when calculating your target amount is to forget about inflation.

I see a lot of people saying if your expenses are 2000 a month you need 600.000 stash to fire.
Thats fine and dandy if you expect to fire within the same year. If you have a ten year plan however it should look like this:

Assumption: 2% inflation means after ten years a total of 21.9%.
For the same standard of living you need 2438 a month. And a stash of 731.400 to be able to fire in 10 years.

Assumption: 4% inflation means after ten years a total of 48%.
For the same standard of living you need 2960 a month. And a stash of 888.000 to be able to fire in 10 years.

Thoughts?

arebelspy

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A common error when calculating your target amount
« Reply #1 on: November 24, 2015, 02:03:32 AM »
That's why everyone uses real dollars. If you assume your wage will grow with inflation, you can use a real return, rather than nominal, and just talk in today's dollars.

Your 888k stache still is 731.4k in 2015 dollars.

As you go along those 10 years, your expenses will rise a bit due to inflation, and your stache amount needed will rise accordingly but it SHOULDN'T affect your time to FIRE, if you used a real rate of return, which already took into account inflation.

It's not a common error, it's something most take into a con on the front end of their calculations (using a reduced rate of return for inflation), rather than the back end (using a nominal rate, and then increasing their numbers for inflation), because it's simpler to think about it that way, and works out the same.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
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Bertram

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Re: A common error when calculating your target amount
« Reply #2 on: November 24, 2015, 02:09:09 AM »
Yeah, I think it shouldn't affect time if you calculate with real return.

I guess it's more a psychological thing of the big goal that people are working towards where they compare their stash with their target number. Or maybe I am just surprised to always see nice rounded numbers for target amounts, which I understand when you start on the journey but it seems after a year or two that number would rise to not so round numbers of which I see very few.

arebelspy

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Re: A common error when calculating your target amount
« Reply #3 on: November 24, 2015, 02:36:06 AM »

Yeah, I think it shouldn't affect time if you calculate with real return.

I guess it's more a psychological thing of the big goal that people are working towards where they compare their stash with their target number. Or maybe I am just surprised to always see nice rounded numbers for target amounts, which I understand when you start on the journey but it seems after a year or two that number would rise to not so round numbers of which I see very few.

No one hits an exact round number, it's just easier to use.

If I spend 34, 843 this year (and anticipate that to be my spending in ER), round up to 25k and 4% rule it and get 875k.  Much easier/cleaner than the actual \$871,075.

And since you won't hit that by an exact dollar when you FIRE, it's "close enough" for targeting towards. Like a missile, you adjust as you go, but a rough number is good enough for shooting towards.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

Ryo

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Re: A common error when calculating your target amount
« Reply #4 on: November 24, 2015, 03:13:07 AM »
As a relative beginner to this, (and not nearly as astute at the numbers side of things as some of our esteemed veteran posters), I admit that I made this mistake.  So thanks OP for taking the time to point it out!

FrugalFan

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Re: A common error when calculating your target amount
« Reply #5 on: November 24, 2015, 06:45:41 AM »
Yeah, I think it shouldn't affect time if you calculate with real return.

I guess it's more a psychological thing of the big goal that people are working towards where they compare their stash with their target number. Or maybe I am just surprised to always see nice rounded numbers for target amounts, which I understand when you start on the journey but it seems after a year or two that number would rise to not so round numbers of which I see very few.

I see what you mean. People set their targets early on using today's dollars, which makes sense. And you can project into the future by assuming your returns account for inflation (e.g. 7% returns but only 4% after inflation). However, as the years go by and your date approaches, your target number should increase to match inflation, unless your expenses have not changed with inflation.

fattest_foot

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Re: A common error when calculating your target amount
« Reply #6 on: November 24, 2015, 09:30:00 AM »
I think this is actually a case of you not understanding the 4% rule, which is what most people use to calculate their target amount.

The 4% rule already incorporates inflation into it. If you remove the inflation, you have the historical 7% return.

FerrumB5

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Re: A common error when calculating your target amount
« Reply #7 on: November 24, 2015, 09:37:17 AM »
Are taxes on withdrawals from both IRA and taxable accounts taken into account in that 4% rule?

nereo

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Re: A common error when calculating your target amount
« Reply #8 on: November 24, 2015, 09:47:21 AM »

I see what you mean. People set their targets early on using today's dollars, which makes sense. And you can project into the future by assuming your returns account for inflation (e.g. 7% returns but only 4% after inflation). However, as the years go by and your date approaches, your target number should increase to match inflation, unless your expenses have not changed with inflation.

Over the past 20-50 year periods, real returns (those adjusted for inflation) have averaged anywhere between 5.1% and 8.4%.  Going forward is anyone's guess, but I plot scenarios where I'll have 6%, 7% and 8% returns.  4% real over several decades could happen, but it would be worse than what we've seen in modern times.
To what degree your post-retirement expenses are influenced by inflation also has a lot to do with personal choices.  Taxes aside, owning (or having a fixed mortgage) on your home and purchasing things used can mean that an ER's expenses might not be as heavily influenced by inflation as your average consumer.

To the OP:  "FI numbers" are like guidelines (see Reb's answer, which I think is very good).  Also, as you get closer to actual retirement inflation matters less and less on your FI.

For example, let's say you project that you'll need \$800k in today's dollars to retire.
If you are estimating a retirement date in 20 years (2035) you might need \$125k-150 in 2035 dollars
BUT, if you are planning on retiring in TWO years then you'll might only need \$840-845k.  The difference in withdrawal amounts would be just \$35/month.  At 2-years-until-retirement inflation becomes a rounding error.  Market fluctuations matter much more.

arebelspy

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Re: A common error when calculating your target amount
« Reply #9 on: November 24, 2015, 09:48:59 AM »

I think this is actually a case of you not understanding the 4% rule, which is what most people use to calculate their target amount.

The 4% rule already incorporates inflation into it. If you remove the inflation, you have the historical 7% return.

The 4% rule has nothing to do with a historical 7% return, or particular inflation amount. It has to do with how much you could have withdrawn historically in a worst case scenario to have a 95% chance of not running out of money after 30 years.  It does take into account inflation, but it's not because of the historical 7% return.

Are taxes on withdrawals from both IRA and taxable accounts taken into account in that 4% rule?

You absolutely need to take taxes into account.  It's one of your expenses.  Along with fees.  That's on you, the person calculating how much you'll need, to account for in your spending (and then save up 25x of that--then when you take out 4%, it covers those taxes, fees, health care, etc. etc.)
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

nereo

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Re: A common error when calculating your target amount
« Reply #10 on: November 24, 2015, 09:50:53 AM »
Are taxes on withdrawals from both IRA and taxable accounts taken into account in that 4% rule?
No - it merely deal with how much you can withdrawal annually and have your portfolio survive.  You need to determine how much you'll pay in taxes each year based on whether your investments are tax-advantaged or not.

For (an extreme) example, let's say you have \$800k in a ROTH IRA (0% taxes) vs \$800k in a taxable account.
BOTH will allow you to withdraw \$32k each year with an equal probability of them surviving.
With the ROTH savings you get to spend \$32k/year
with the taxable account you will likely get closer to \$29k/year depending on your tax rate and deductions.

FerrumB5

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Re: A common error when calculating your target amount
« Reply #11 on: November 24, 2015, 09:53:31 AM »
Quote: "You absolutely need to take taxes into account.  It's one of your expenses.  Along with fees.  That's on you, the person calculating how much you'll need, to account for in your spending (and then save up 25x of that--then when you take out 4%, it covers those taxes, fees, health care, etc. etc.)"

A first approximation would be adding 15-20% (relative) to that 4% rule, i.e. 4*1.2 = 4.8% including taxes on withdrawals (given 15-20% bracket and no other income), right? Not going into detailed calculations, which will be more accurate of course

Prairie Stash

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Re: A common error when calculating your target amount
« Reply #12 on: November 24, 2015, 09:56:54 AM »
At 10 years out the math usually fails. In the real world inflation isn't exactly 3% every year and you don't achieve exactly 7% returns. Its a quick approximation, in my mind I have a 10 year plan give or take 2 years. When I'm 5 years out it'll be plus/minus a year and as the date approaches become more exact. I think the error is trusting simple formulas and expecting precise results.

One of my complaints is the incorrect calculating of inflation. Inflation is calculated on a standard basket of goods; most of which I don't buy. My personal inflation rate is lower than the national rate since I'm not buying a lot of the goods that bring the average rate up. For a case study review MMM spending and see if it matches inflation rate over the last 5 years, has his spending gone up \$2500 (2% a year for 5 years)? Sol, in another thread, has a great way to achieve no inflation on his power bills by installing solar, constant bills for 30 years instead of the annual increases. I'd wager his personal inflation rate is also lower than the national rate.

JZinCO

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Re: A common error when calculating your target amount
« Reply #13 on: November 24, 2015, 10:00:15 AM »
The 4% rule already incorporates inflation into it. If you remove the inflation, you have the historical 7% return.
The rule does include inflation.
But, my understanding is that's not quite how SWR is derived. SWR is a product of accounting for sequence of returns risk and not a simple 7% nominal return-3% inflation=4% real return. 7% is a historic real avg annual return of (sp500?) stocks (with historic real CAGR at 6.55 according to Wade Pfau).
Wade Pfau actually states that those who are foolish enough (calling out Dave Ramsey specifically) to think that you can set your SWR by just subtracting nominal returns from inflation are in for a big surprise.
---
On another point, adjustment for inflation is baked into the cake as noted previously by using real returns for estimating growth of a stache.
However, how do you know when you hit your goal from when you initially set your goal? See this example:
(Assumptions)
Stache in 2015: 500,000
Target number in 2015 dollars: 1,000,000
Real CAGR: 6.55%
Inflation 3%
(Results)
Time to reach target: ~11yr, assuming no contributions.
Value in 2015 dollars at year 2026: 1,000,000
Value in 2026 dollars at year 2026: 1,363,660

I think the OP has a point in that one needs to be mindful that the nominal target amount increases with inflation. If you never adjust your real target stache through the years...
Value in 2022.8 dollars at year 2022.8: 1,000,000
Value in 2015 dollars at year 2022.8: 817,500
Though one set their target stache to 1,000,000 in 2015, they would be mistaken to retire with 1,000,000 in 2022.8. In reality, by 2022.8, one would revisit their plan and adjust the nominal amount of their target stache appropriately, and realize they need to wait until 2026. Or, alternatively change their real target amount to account for lifestyle changes.

edit: 6 replies while I was typing this. Hope I didn't repeat anyone.
« Last Edit: November 24, 2015, 10:41:31 AM by JZinCO »

arebelspy

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Re: A common error when calculating your target amount
« Reply #14 on: November 24, 2015, 10:02:07 AM »

Quote: "You absolutely need to take taxes into account.  It's one of your expenses.  Along with fees.  That's on you, the person calculating how much you'll need, to account for in your spending (and then save up 25x of that--then when you take out 4%, it covers those taxes, fees, health care, etc. etc.)"

A first approximation would be adding 15-20% (relative) to that 4% rule, i.e. 4*1.2 = 4.8% including taxes on withdrawals (given 15-20% bracket and no other income), right? Not going into detailed calculations, which will be more accurate of course

4.8% may not be sustainable.

You don't calculate your expenses, except for some things, count those as 4%, then add other random stuff.

You take your initial stache, and take 4% of that. Will it cover your taxes, investment fees, and all other expenses. No?  Keep working. Yes?  You're good.

You don't increase to 4.8% or something for taxes.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

nereo

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Re: A common error when calculating your target amount
« Reply #15 on: November 24, 2015, 10:07:48 AM »
Quote: "You absolutely need to take taxes into account.  It's one of your expenses.  Along with fees.  That's on you, the person calculating how much you'll need, to account for in your spending (and then save up 25x of that--then when you take out 4%, it covers those taxes, fees, health care, etc. etc.)"

A first approximation would be adding 15-20% (relative) to that 4% rule, i.e. 4*1.2 = 4.8% including taxes on withdrawals (given 15-20% bracket and no other income), right? Not going into detailed calculations, which will be more accurate of course
I suppose you could do it this way if that's what works for you. Typically this would be considered a bit backwards, as most people find the WR they are comfortable with (e.g. 4% gives you 95% success over 30 year periods) and then see how much they need to save to have \$X at Y% WR.
I think 20% considerably higher than I'd pay in taxes in ER, especially under current tax law (0-15% for capitol gains tax, plus 0% on ROTH contributions, etc, minus standard deductions).
I find 10-12% to be much closer to what I expect to pay in taxes (and I consider even that to be a conservative estimation).

Personally though, I find it easier to think of my withdrawal amount as my 'income' for the year.  I ask myself: if I have my house paid off can I live off \$32k/year (including paying xx% in taxes)?   It's similar to how we think about jobs; when you are offered a job you (should) have a sense how much you can spend per month/year at that salary.

But whwatever is easiest for you.

Shane

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Re: A common error when calculating your target amount
« Reply #16 on: November 24, 2015, 10:20:06 AM »
One of my complaints is the incorrect calculating of inflation. Inflation is calculated on a standard basket of goods; most of which I don't buy. My personal inflation rate is lower than the national rate since I'm not buying a lot of the goods that bring the average rate up. For a case study review MMM spending and see if it matches inflation rate over the last 5 years, has his spending gone up \$2500 (2% a year for 5 years)? Sol, in another thread, has a great way to achieve no inflation on his power bills by installing solar, constant bills for 30 years instead of the annual increases. I'd wager his personal inflation rate is also lower than the national rate.

This makes a lot of sense. My family and I also don't consume many of the things that are counted in the CPI. We're especially looking forward to not needing to own a car in FIRE. We've lived without a vehicle before and loved it. Gas is cheap now, but chances are it won't stay that way...

JZinCO

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Re: A common error when calculating your target amount
« Reply #17 on: November 24, 2015, 10:28:54 AM »
One of my complaints is the incorrect calculating of inflation. Inflation is calculated on a standard basket of goods; most of which I don't buy. My personal inflation rate is lower than the national rate since I'm not buying a lot of the goods that bring the average rate up. For a case study review MMM spending and see if it matches inflation rate over the last 5 years, has his spending gone up \$2500 (2% a year for 5 years)? Sol, in another thread, has a great way to achieve no inflation on his power bills by installing solar, constant bills for 30 years instead of the annual increases. I'd wager his personal inflation rate is also lower than the national rate.

This makes a lot of sense. My family and I also don't consume many of the things that are counted in the CPI. We're especially looking forward to not needing to own a car in FIRE. We've lived without a vehicle before and loved it. Gas is cheap now, but chances are it won't stay that way...
Housing is my largest expense and I rent. The real growth of housing prices is pretty low (using Case Shiller). If I assume my rent tracks with housing prices, the CPI is a fair measure to estimate how my nominal expenses will rise with inflation.
« Last Edit: November 24, 2015, 10:35:15 AM by JZinCO »

k290

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Re: A common error when calculating your target amount
« Reply #18 on: November 24, 2015, 10:40:51 AM »
The 4% rule already incorporates inflation into it. If you remove the inflation, you have the historical 7% return.
The rule does include inflation.
But, my understanding is that's not quite how SWR is derived. SWR is a product of accounting for sequence of returns risk and not a simple 7% nominal return-3% inflation=4% real return. 7% is a historic real avg annual return of (sp500?) stocks (with historic real CAGR at 6.55 according to Wade Pfau).
Wade Pfau actually states that those who are foolish enough (calling out Dave Ramsey specifically) to think that you can set your SWR by just subtracting nominal returns from inflation are in for a big surprise.

I am aware of this but for interests sake can someone link to where Pfau calls out Ramsey?

JZinCO

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Re: A common error when calculating your target amount
« Reply #19 on: November 24, 2015, 10:45:11 AM »
The 4% rule already incorporates inflation into it. If you remove the inflation, you have the historical 7% return.
The rule does include inflation.
But, my understanding is that's not quite how SWR is derived. SWR is a product of accounting for sequence of returns risk and not a simple 7% nominal return-3% inflation=4% real return. 7% is a historic real avg annual return of (sp500?) stocks (with historic real CAGR at 6.55 according to Wade Pfau).
Wade Pfau actually states that those who are foolish enough (calling out Dave Ramsey specifically) to think that you can set your SWR by just subtracting nominal returns from inflation are in for a big surprise.

I am aware of this but for interests sake can someone link to where Pfau calls out Ramsey?
It's a good listen. They hit alot of key points aside from the one I mentioned such as planning using a CAGR, not average annual return, because of sequence of returns in the accumulation phase.
They also call into question Ramsey's assumed rate of return of 12%.

RyanAtTanagra

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Re: A common error when calculating your target amount
« Reply #20 on: November 24, 2015, 10:58:27 AM »
Good topic, I'm starting to be aware that I've been guilty of this, because things for me are clouded by doing geographical arbitrage as I build the stache.  My FI number is based off my COL when I started on this journey, at which point I lived in Ohio.  Shortly after, I moved to SF but kept that number because I don't plan to retire out here, but will most likely be moving somewhere with a similar COL as before.  But that was 5 years ago now and I doubt if I were to move back to Ohio my expenses would be the same, so I need to adjust that number.  I guess it's an easy enough calculation, but damnit you just moved my FIRE date back :-(

ZiziPB

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Re: A common error when calculating your target amount
« Reply #21 on: November 24, 2015, 11:05:05 AM »

If I spend 34, 843 this year (and anticipate that to be my spending in ER), round up to 25k and 4% rule it and get 875k.  Much easier/cleaner than the actual \$871,075.

And since you won't hit that by an exact dollar when you FIRE, it's "close enough" for targeting towards. Like a missile, you adjust as you go, but a rough number is good enough for shooting towards.

Careful with that rounding Rebel!  If you round \$34,843 to \$25K, you may come up short with the stash :-)

Bearded Man

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Re: A common error when calculating your target amount
« Reply #22 on: November 24, 2015, 11:28:38 AM »
I think this is actually a case of you not understanding the 4% rule, which is what most people use to calculate their target amount.

The 4% rule already incorporates inflation into it. If you remove the inflation, you have the historical 7% return.

Actually that's not accurate. The 4% has to do with how much you are taking out of your portfolio to live on every year. Nominal historical returns are 12% with dividends. Adjusted for inflation they are 9%. Theoretically, your stash should continue to grow even as you are drawing down on your portfolio.

A common error IMO when targeting target amounts is not accounting for taxes, large legal or medical expenses, or lifestyle changes (you get someone pregnant, get married, parents need help, etc.)

nereo

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Re: A common error when calculating your target amount
« Reply #23 on: November 24, 2015, 11:46:09 AM »

Actually that's not accurate. The 4% has to do with how much you are taking out of your portfolio to live on every year. Nominal historical returns are 12% with dividends. Adjusted for inflation they are 9%. Theoretically, your stash should continue to grow even as you are drawing down on your portfolio.

Careful - this is incredibly misleading.  Speaking strictly about the SP500, the  maximum real-adjusted returns over 30 year periods is 10.2% - when speaking about nominal historial returns 12% is among the highest 30 year periods.  The median real-adjusted returns over 30 year periods is 7.1% (not 9%!).  There have been periods when inflation adjusted returns has hit 9%, but that is above the median average.

Anyone who is hoping for 30+ years of 9% real-adjusted returns going forward is hoping for that the next 30 years will come very close to the best 30 year period in history.

JZinCO

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Re: A common error when calculating your target amount
« Reply #24 on: November 24, 2015, 11:59:31 AM »

Actually that's not accurate. The 4% has to do with how much you are taking out of your portfolio to live on every year. Nominal historical returns are 12% with dividends. Adjusted for inflation they are 9%. Theoretically, your stash should continue to grow even as you are drawing down on your portfolio.

Careful - this is incredibly misleading.  Speaking strictly about the SP500, the  maximum real-adjusted returns over 30 year periods is 10.2% - when speaking about nominal historial returns 12% is among the highest 30 year periods.  The median real-adjusted returns over 30 year periods is 7.1% (not 9%!).  There have been periods when inflation adjusted returns has hit 9%, but that is above the median average.

Anyone who is hoping for 30+ years of 9% real-adjusted returns going forward is hoping for that the next 30 years will come very close to the best 30 year period in history.

planning using a CAGR, not average annual return, because of sequence of returns in the accumulation phase.
This too. Arithmetic means of returns are higher than the actual geometric means and will give you a too-rosy estimate.
And in case anyone was wondering, the compound annual inflation rate is about the same as the average annual inflation rate, so no need to worry about that.
edit: by that, I mean factoring in geometric inflation rate
« Last Edit: November 24, 2015, 03:14:23 PM by JZinCO »

EscapeVelocity2020

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Re: A common error when calculating your target amount
« Reply #25 on: November 24, 2015, 12:17:02 PM »
I didn't have an appreciation for how complicated 'inflation' can be when planning for a 30+ year retirement until I tried to figure out a way to plan for it.  For example, I'm 40 years old, so these low reported inflation numbers make me feel good, but also 'hurt's' my nominal paycheck increase and future COLA'ed Social Security.  So what I really want is for the government to represent 'inflation' accurately, but do I believe in the basket of goods and how they use a 'chained' factor to compensate for 'non-monetary' improvements?  A similar thing happens with GDP - people are happy that it goes up, but don't understand that certain things like technological progress reduce GDP (like when encyclopedias are suddenly available online essentially for free...).

These are interesting times that we live in and, for the most part, are blissfully unaware of what may happen in our life time.  After taking a long, hard look, I also figured that I was better off ignoring inflation for the time being.  These are the 1970's, man.  And how do you estimate future inflation numbers for things that I won't be able to live without but haven't been invented yet.  And there's always the option to be one of those hapless oldersters with the equivalent of aol on my flip phone.  So persoanlly, I think I've hit my target number, and I'm just going to make choices based on that :)

arebelspy

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A common error when calculating your target amount
« Reply #26 on: November 24, 2015, 02:59:13 PM »
Inflation is, IMO, the number one threat to an early retiree's success.  Much more so than a market crash.  Your portfolio can recover from a market crash. It's a lot harder to recover from eroded buying power.

It's something I think every person retiring early should study and model, in detail.  Ignore it at your own peril.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

EscapeVelocity2020

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Re: A common error when calculating your target amount
« Reply #27 on: November 24, 2015, 03:42:22 PM »
Inflation is, IMO, the number one threat to an early retiree's success.  Much more so than a market crash.  Your portfolio can recover from a market crash. It's a lot harder to recover from eroded buying power.

It's something I think every person retiring early should study and model, in detail.  Ignore it at your own peril.

That's what I thought too, but how do you actually model it?  Having not lived through a period of high inflation, my best bets have been a hedge with a low rate fixed mortgage, front-loading spending more now, and diversify my passive income streams (although TIPS and I-bonds have been about my worst investments ever).

https://en.wikipedia.org/wiki/United_States_Chained_Consumer_Price_Index - This was a good eye-opener on why it is important but subjective, and hence so complicated.  What do you do about the fact that low inflation today is partially because of the government's new, flexible definition compared to those high-inflation, slow tech innovation years in the past?  Even ER calculators gloss over this, by just using the inflation as reported at face value, although the formula and philosophy has changed...

brooklynguy

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Re: A common error when calculating your target amount
« Reply #28 on: November 24, 2015, 03:44:25 PM »
Inflation is, IMO, the number one threat to an early retiree's success.  Much more so than a market crash.  Your portfolio can recover from a market crash. It's a lot harder to recover from eroded buying power.

It's something I think every person retiring early should study and model, in detail.  Ignore it at your own peril.

I second this.  In addition, some of the comments in this thread are starting to veer close to the common (and dangerous) trap of thinking that frugal early retirees are somehow less susceptible to inflation than others.  Even if your expenses are low, those low expenses are still subject to inflation.  And even if your specific expenses have historically risen at a lower rate than the corresponding national average inflation rate (based on standards like the consumer price index), that trend may not persist into the future.  Being price-conscious and having flexibility to make price-based substitutions in your expenditures can mitigate inflation's impact, but there's only so much you can do to protect the purchasing power of your dollars when prices rise across the board.

beltim

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Re: A common error when calculating your target amount
« Reply #29 on: November 24, 2015, 03:47:47 PM »
https://en.wikipedia.org/wiki/United_States_Chained_Consumer_Price_Index - This was a good eye-opener on why it is important but subjective, and hence so complicated.  What do you do about the fact that low inflation today is partially because of the government's new, flexible definition compared to those high-inflation, slow tech innovation years in the past?  Even ER calculators gloss over this, by just using the inflation as reported at face value, although the formula and philosophy has changed...

Almost no one uses the Chained CPI.  It's not used to calculate any government payments (e.g. Social Security) or revenue (tax brackets, etc.).

Though there are proposals to use the Chained CPI for some purposes in the future, it's just not accurate the say that "the formula and philosophy has chained"

bacchi

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Re: A common error when calculating your target amount
« Reply #30 on: November 24, 2015, 04:05:06 PM »
Re: government inflation accuracy

http://bpp.mit.edu/usa/

BTDretire

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Re: A common error when calculating your target amount
« Reply #31 on: November 24, 2015, 04:32:16 PM »

For (an extreme) example, let's say you have \$800k in a ROTH IRA (0% taxes) vs \$800k in a taxable account.
BOTH will allow you to withdraw \$32k each year with an equal probability of them surviving.
With the ROTH savings you get to spend \$32k/year
with the taxable account you will likely get closer to \$29k/year depending on your tax rate and deductions.

I have a question about those taxes.
Say \$32K gross, minus standard deduction \$13K= 19K minus 2 personal deductions of \$4k ea,
now we're down to \$11K.
Are there any taxes on a \$32k income for two people?
I don't know, just trying to get some idea for planning.

beltim

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Re: A common error when calculating your target amount
« Reply #32 on: November 24, 2015, 04:42:11 PM »

For (an extreme) example, let's say you have \$800k in a ROTH IRA (0% taxes) vs \$800k in a taxable account.
BOTH will allow you to withdraw \$32k each year with an equal probability of them surviving.
With the ROTH savings you get to spend \$32k/year
with the taxable account you will likely get closer to \$29k/year depending on your tax rate and deductions.

I have a question about those taxes.
Say \$32K gross, minus standard deduction \$13K= 19K minus 2 personal deductions of \$4k ea,
now we're down to \$11K.
Are there any taxes on a \$32k income for two people?
I don't know, just trying to get some idea for planning.

In that example:
If that's ordinary income (withdrawals from a 401k, for example), the Federal income taxes would be about \$1100.

If it's all long-term capital gains (sales of stock held more than 1 year), there would be no Federal income taxes on that amount.

If it's withdrawals from a Roth IRA, then would be no Federal income taxes on that amount.

kpd905

• Handlebar Stache
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Re: A common error when calculating your target amount
« Reply #33 on: November 24, 2015, 04:43:31 PM »

For (an extreme) example, let's say you have \$800k in a ROTH IRA (0% taxes) vs \$800k in a taxable account.
BOTH will allow you to withdraw \$32k each year with an equal probability of them surviving.
With the ROTH savings you get to spend \$32k/year
with the taxable account you will likely get closer to \$29k/year depending on your tax rate and deductions.

I have a question about those taxes.
Say \$32K gross, minus standard deduction \$13K= 19K minus 2 personal deductions of \$4k ea,
now we're down to \$11K.
Are there any taxes on a \$32k income for two people?
I don't know, just trying to get some idea for planning.

If you use both traditional accounts and a taxable account, a married couple can have about \$90,000 of total income without paying any federal tax.  See this article: http://www.gocurrycracker.com/go-curry-cracker-2014-taxes/

For your example, if all of your \$32k income was from a traditional IRA, your federal tax owed would be \$1130 (2016 brackets), because you'd have \$11,300 all in the 10% bracket after the standard deduction and personal exemptions.

You could have income either come from a Roth IRA or a taxable account via dividends or capital gains to eliminate that tax.  Or you can just accept that \$1130 tax on \$32,000, or a 3.5% effective rate, is pretty damn good.

You can run numbers with this calculator here: https://www.calcxml.com/calculators/federal-income-tax-calculator

Edit: Beltim covered most of these points while I was typing this up.
« Last Edit: November 24, 2015, 05:34:21 PM by kpd905 »

EscapeVelocity2020

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Re: A common error when calculating your target amount
« Reply #34 on: November 24, 2015, 07:07:29 PM »
https://en.wikipedia.org/wiki/United_States_Chained_Consumer_Price_Index - This was a good eye-opener on why it is important but subjective, and hence so complicated.  What do you do about the fact that low inflation today is partially because of the government's new, flexible definition compared to those high-inflation, slow tech innovation years in the past?  Even ER calculators gloss over this, by just using the inflation as reported at face value, although the formula and philosophy has changed...

Almost no one uses the Chained CPI.  It's not used to calculate any government payments (e.g. Social Security) or revenue (tax brackets, etc.).

Though there are proposals to use the Chained CPI for some purposes in the future, it's just not accurate the say that "the formula and philosophy has chained"

I didn't say 'chained', but I am also trying to raise awareness to ER's about this move to chain CPI since it adds a new wrinkle in an already biased system (biased against longevity and ER).  But measures of CPI have changed, I guess I wasn't very clear, but examples are included in the link...
Quote
Currently, the Bureau of Labor Statistics computes each month average prices of 211 different categories of goods and services in 38 different urban geographical areas, totaling 8,018 different elementary indices. From these, higher-level indices are obtained as weighted averages of these elementary indices, using different weights for different categories of goods and services nationwide or for different groups of consumers. One set of weights is used to obtain a consumer price index (CPI) for all urban consumers (CPI-U). Another is used to compute a CPI for urban wage earners and clerical workers (CPI-W). The weights for CPI-U and CPI-W are currently updated in January of every even-numbered year to correct for "substitution bias", the idea that consumers will change their buying patterns to keep their cost of living from rising as quickly as inflation.
...
In 1996, the Advisory Committee to Study the Consumer Price Index (The Boskin Commission) estimated that in 1996 CPI-W (used to adjust Social Security) over-estimated inflation 1.1 percent. The BLS responded by making changes to the CPI-U and CPI-W, which included an adjustment to compensate for (upper-level substitution bias), performed each January of an even-numbered year.

EscapeVelocity2020

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Re: A common error when calculating your target amount
« Reply #35 on: November 24, 2015, 07:09:45 PM »
...Or if you really want to read a lot of boring, conflicting, and confusing stuff about CPI - https://en.wikipedia.org/wiki/United_States_Consumer_Price_Index

Bateaux

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Re: A common error when calculating your target amount
« Reply #36 on: November 25, 2015, 02:42:16 AM »
Looking at the nearly 11 months of this years stock market results, I've realized that I must push my number higher.  I've come to the decision that I really don't want my nest egg to decline ever.  Even once FIRE or just retired rather I want my nest egg growing.  For 2015 I'm only up about 2.8%.  That isn't enough income to live on without drawing down.  My new target is 2 million liquid.   In retirement I never want to drop below 2 million even when receiving income from it.  My planned withdrawl rate is 3%.  Hopefully we'll average a little bit better in coming years.

arebelspy

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Re: A common error when calculating your target amount
« Reply #37 on: November 25, 2015, 03:11:40 AM »
With market fluctuations, your account WILL drop, even if you have a WR of < 1%.

Unless you keep it in cash, in which case inflation will eat you up. The only way around that is to have a short retirement. Retire late, die early.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

Rural

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Re: A common error when calculating your target amount
« Reply #38 on: November 25, 2015, 03:25:54 AM »
Just a quick caution for those of you thinking we mustachians are less susceptible to inflation: I remember it hitting,hard, on a month to month basis, and not on cars, new appliances, and other fancy consumer goods, but on bread, flour, milk, sugar, eggs. Never came back down again, of course.

And some of our favored grocery strategies won't help much in that scenario. One of my cookbooks still has a coupon I've been using as a bookmark - 5 cents off a can of cocoa. Cocoa became unaffordable before the coupon got used, and the coupon became useless, because, sensibly enough, it was based on prices at the time it was printed.

Anyway, we can't ignore it. Especially if you're looking at a 40-year retirement; the period I'm thinking of was right at 40 years ago.
« Last Edit: November 25, 2015, 03:27:27 AM by Rural »

arebelspy

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Re: A common error when calculating your target amount
« Reply #39 on: November 25, 2015, 03:52:44 AM »
And mathematically, you can't be immune to inflation. Because even if you do things like go off grid to reduce expenses, whatever expenses you DO have will go up with inflation.

Sure, maybe you get solar panels to prevent your electricity going up...but you won't count electricity in your expenses then.  Those expenses you do have to pay for will go up over time.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

Frs1661

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Re: A common error when calculating your target amount
« Reply #40 on: November 25, 2015, 04:19:31 AM »

Looking at the nearly 11 months of this years stock market results, I've realized that I must push my number higher.  I've come to the decision that I really don't want my nest egg to decline ever.  Even once FIRE or just retired rather I want my nest egg growing.  For 2015 I'm only up about 2.8%.  That isn't enough income to live on without drawing down.  My new target is 2 million liquid.   In retirement I never want to drop below 2 million even when receiving income from it.  My planned withdrawl rate is 3%.  Hopefully we'll average a little bit better in coming years.

An 11-month timeline is nothing, and you saw an almost 3% gain. What will you do if we see another ~50% drawdown like we saw in the beginning of the 'great recession'? Even a significant savings rate (i.e. working forever) doesn't ensure your portfolio won't drop year over year. If you haven't read the jlcollinsnh stock series I suggest you do so to get a better idea of the ride you're in for as an equities-heavy investor.

Have you considered investing in real estate? Perhaps the psychology of receiving rent checks greater than your cash needs every month would be more your style?

Sent from my Nexus 4 using Tapatalk

Bateaux

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Re: A common error when calculating your target amount
« Reply #41 on: November 25, 2015, 04:43:37 AM »
Real estate isn't the answer for me.  I've got a rental now that I'm not renting because it is a hassle.   I want passive income only in fire from investments.  I'm not against part time work for a few months a year to enhance earnings.   I fell OMY syndrome for a while now.  I have a new position at work and no longer hate my job.

EscapeVelocity2020

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Re: A common error when calculating your target amount
« Reply #42 on: November 25, 2015, 06:53:16 AM »
If you really worry about inflation, having a job is about the only proven antidote.  Asset returns and getting to liquidity lag but buying food and utilities are real time events.  During times of high inflation, companies raise wages to fight for workers and stay in business.  And if there is hyperinflation, the system eventually collapses and other means of exchange arise.

I'm still waiting for the ER answer to how they are truly hedging for higher inflation.  I've heard people saying not to ignore it (and I agree) but then leave it at that.  I'm even open to discussing if blog income would hold up well enough to keep pace with inflation, I don't think it would since it isn't an essential commodity and supply would become flooded.

Anyway, good discussion, I'm just hoping for more new ideas.

brooklynguy

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Re: A common error when calculating your target amount
« Reply #43 on: November 25, 2015, 08:35:07 AM »
If you really worry about inflation, having a job is about the only proven antidote.

Why do you say this?  Like wages, many other things have historically been highly correlated with inflation, due to similar market forces (such as rental prices--so owning rental property can be a good inflation hedge).

But neither wages nor rental incomes nor stock prices nor anything else besides currency value itself is guaranteed to fluctuate in perfect lockstep with overall inflation.  That's why having a fixed rate mortgage, as you mentioned earlier, is one of the best inflation hedges available--the value of borrowed dollars will necessarily fall with inflation.

The problem is that inflation is not the only risk in need of hedging, and focusing too specifically on any single risk (to the exclusion of all others) is itself a risky strategy, reflecting the inherent dangers of overspecialization.  Here's a post I made a while back on a similar topic in another thread:

Suppose there were a deflationary period for a decade or so.  Would that affect things?

Yes, a decade-long period of deflation would of course "affect things" (an expression that is a study in understatement), as would a period of hyperinflation, stagflation, or nuclear annihilation.  It goes without saying that the past does not necessarily predict the future, but the cfiresim results do tell us that after accounting for all covered historical periods (including the Great Depression, etc.), over 95% of the time it was better to use the proceeds of a 30-year mortgage with a 4% interest rate for investments rather than for prepayment.  Is it possible things could turn out differently for the person investing today?  Of course!  We could be in situation like one of the historical 5% failure cases, or the future could even turn out to be worse than any period ever to have occurred in the past.  But note that if over the next 30 years a standard stock/bond portfolio fails to outperform a mortgage with a rate like the ones available today, then anyone planning to start an MMM-style retirement today in reliance on the 4% rule is going to run out of money.

So what's the solution?  Any strategy that will perfectly equip you to deal with a deflationary spiral (such as, say, converting all of your assets into gold), or any other specific worst case scenario, will also leave you very poorly equipped to deal with all the other potential (and perhaps more likely) outcomes.  In my view, all things considered, a very sensible strategy to take is to exploit the low interest rates available on today's 30-year mortgages to increase your exposure to a well-diversified portfolio of low-cost index funds.

This JL Collins article makes for some good reading about how an internationally diversified portfolio provides some level of hedging protection against both inflation and deflation:

http://jlcollinsnh.com/2014/05/27/stocks-part-xxii-stepping-away-from-reits/

arebelspy

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A common error when calculating your target amount
« Reply #44 on: November 25, 2015, 08:54:39 AM »
If you really worry about inflation, having a job is about the only proven antidote.  Asset returns and getting to liquidity lag

Lag a little, sure, but if you own a portion of that business (via stock investments, even index funds) that are selling the assets at inflated prices, you're earning that extra money.

Rents rise with inflation, but also lag. If tenants are on a year lease, you need to wait to raise the rent. Even when you do raise it,

Quote
but buying food and utilities are real time events.

Sure.

But your solution, a job, doesn't work either.

When have you seen a job give daily or weekly performance reviews and raises based on inflation?

Food and utilities raise real time, but jobs and wages don't, they lag even harder than asset prices.

When you have an annual review, at best, and get a small cost of living increase (even less than inflation was) and you're happy to take it, because the economy is rough, you're definitely lagging inflation, and were for that whole year before you got the raise, and the whole year until the next one (even if they didn't put you below, like I said, but they did raise it to match inflation once/yr, you were lagged behind that whole year, and immediately fall behind again).

WalMart raises prices on food?  Chevron raises gas prices?  Electric company raises energy prices?

Good thing I own all of them via index funds, so when people pay those higher prices, I'M the one profiting, all along the way, even if the prices of the stocks haven't gone up a lot to reflect it, yet (lag).

That's one major way to beat inflation--own productive assets.

Too much of your money in bonds?  Cash?  Ouch. High equities, real estate, those are key things to beating inflation.  They have higher volatility, yes, but allow that upside that fixed return assets do not, to adjust up for inflation.

And they lag way less than a job.

This is what I meant by saying you should study and research inflation. Because "a job" as a solution while putting down certain assets that do help is plain silly, IMO.  :)

And, as BG says, don't protect too hard against one risk (inflation) at the risk of another (deflation, volatility sequence of returns risk, etc.), but definitely protect against inflation, and the way to do this is via proper asset allocation.
« Last Edit: November 25, 2015, 08:56:16 AM by arebelspy »
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

EscapeVelocity2020

• Magnum Stache
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Re: A common error when calculating your target amount
« Reply #45 on: November 25, 2015, 09:31:27 AM »
@BG and ARS -  To a limited extent, having real estate (or 'productive assets') is a hedge, but rent seeking is much less responsive to inflation than having active income during inflation.  This is one time, IMHO, where Piketty's general conclusion (r>g) is reversed.

Just from my limited experience (being in the oil patch in 2006-2007 when crude shot up to \$150/bbl), I had not one, not two, but several consecutive raises as the year went along.  And experienced colleagues were still quitting their jobs for more money elsewhere!  First there was an unusually generous performance review.  Then the CEO gave an inspirational townhall speech, ending with a 5% across the board raise (things had been bad not that long ago, so salaries had a lot of catching up to do).  Mandatory paid overtime was instituted (effectively a 25% raise, going from 40 to 50 hours), and accelerated performance reviews and generous promotions followed that ... and even then I still left the company and got hired on elsewhere with a salary increase.  And also, from what I've read and heard about during the last period of high inflation in the 70's, I firmly believe that 'inflation' makes companies do whatever they can to keep the rainmakers (a.k.a. the employees).

I'm sure you can corroborate this.  However, very few sources speak effectively to being retired during 'high inflation'.  Most people seem pretty scarred by it, with little good advice (JLCollin's post on inflation was mentioned, which ends on a pretty low note).

Sorry I'm not digging deeper in to this right now, I want to and I hope you do.  I'm hoping someone on this forum offers a more compelling inflation resistant income stream than a salary or TIPS (with a link), but I'm not convinced yet.

arebelspy

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Re: A common error when calculating your target amount
« Reply #46 on: November 25, 2015, 09:36:34 AM »
Your example of raises is in a boom time with lack of employees.

Not in an inflationary time.  Look at the stagflation from the 70s.  Wages weren't keeping up with inflation real time, and workers were scared to leave jobs in a bad economy.  A job is not a "good" solution to inflation. It's okay, but lags even worse than most good investments.

Piketty's general conclusion has not been borne out historically, and says nothing about inflation.  I know if goods cost more, I want to be the one owning and selling them, not the one buying them.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

Prairie Stash

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Re: A common error when calculating your target amount
« Reply #47 on: November 25, 2015, 09:57:38 AM »
And mathematically, you can't be immune to inflation. Because even if you do things like go off grid to reduce expenses, whatever expenses you DO have will go up with inflation.

Sure, maybe you get solar panels to prevent your electricity going up...but you won't count electricity in your expenses then.  Those expenses you do have to pay for will go up over time.
I agree everyone sees inflation however posted inflation rates are based off you purchasing electricity. Personal inflation rates can be higher or lower than the national average. After all an average means 50% of people will see higher inflation just like 50% of us will see lower.

Other examples include in retirement I might take university classes for fun, I expect tuition to increase 5%/year. If I say my inflation is only 3% I might have a problem in a few years (lots of info on rising tuition beating inflation). I've also personally seen deflation in gasoline (over the last 2 years), heating (over the past 10), television (over 5 years), electronics (15 years) and inflation on food, clothing, water, electricity. Take a look at each budget category and you can calculate out personal inflation for yourself, some people might even have experienced deflation, mathematically its possible. Some commodities have 100 years trends of rising slower than inflation, some have increased higher than inflation over 100 years.

My point remains the same, inflation is a broad estimate and the 4% rule needs to be customized to an individual. Estimating inflation is a big problem long term, high or low. A simple calculation will never do it justice, its much too complicated. The simple approach of estimating 3% however has a built in safety buffer, I'm not saying that's good or bad.

From 2010-2014 MMM has decreased spending by 5.77%, excluding mortgage (which he paid off, it would show massive deflation in housing). Mathematically MMM is showing deflation over 5 years (-1% inflation). Most people don't post as much detail for calculations, my thanks to MMM. I expect his inflation will trend up over the next 20 years, but will it average 3%?

Data: 2014 spend \$25,330 (0.50% increase), 2013 \$25,182 (0.54%) 2012 \$25,046 (-7.08) 2011 \$26,953 (0.26%) 2010 spend of \$26,882.

arebelspy

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Re: A common error when calculating your target amount
« Reply #48 on: November 25, 2015, 10:14:31 AM »

And mathematically, you can't be immune to inflation. Because even if you do things like go off grid to reduce expenses, whatever expenses you DO have will go up with inflation.

Sure, maybe you get solar panels to prevent your electricity going up...but you won't count electricity in your expenses then.  Those expenses you do have to pay for will go up over time.
I agree everyone sees inflation however posted inflation rates are based off you purchasing electricity.

It's a percentage. If you don't purchase something, fine, but the percentage on the stuff you do will still increase with inflation.

Unless you have a crystal ball on things that will go up faster than everything else, skewing the average inflation up, and causing yours to be lower, then there's no reason to think the goods you do purchase will be lower. In other words, your inflation should track the normal inflation rate, on average, regardless of whether you buy certain things.  Inflation is something an early retiree can't ignore, unless they literally spend zero.

This is a major problem with people who spend very little, and think they'll be immune to inflation. The little they do spend should inflate with everything else, as raw goods, cost of labor, etc. rises.
I am a former teacher who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and am now settled with three kids.
If you want to know more about me, this Business Insider profile tells the story pretty well.
I (rarely) blog at AdventuringAlong.com. Check out the Now page to see what I'm up to currently.

brooklynguy

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Re: A common error when calculating your target amount
« Reply #49 on: November 25, 2015, 11:22:51 AM »
My point remains the same, inflation is a broad estimate and the 4% rule needs to be customized to an individual. Estimating inflation is a big problem long term, high or low. A simple calculation will never do it justice, its much too complicated. The simple approach of estimating 3% however has a built in safety buffer, I'm not saying that's good or bad.

Why do you need to estimate inflation?  As explained in a few of the posts upthread, the 4% rule has nothing to do with any specific assumed level of inflation (3% or otherwise), or any specific assumed level of market returns.  You should build your retirement strategy in a way that protects against inflation, but not on the basis of any specific predicted level of inflation in particular.