Retirement planning involves a lot of financial decisions, and one of the most important is estimating the inflation rate you should use when developing your plans.
Unfortunately, this can be harder than it seems for many people—especially those just getting started in retirement planning or unsure about how economic trends could affect their future.
This blog post will discuss why it’s important to consider future retirement inflation rates with your retirement savings.
We will also provide several strategies to help you estimate yours accurately and solve inflation worries.
With all the legal or tax advice included here, you’ll have no problem determining what reasonable rising inflation rate to use while creating and fine-tuning your plan!
The Assumed Rate Of Return
I have observed that people estimate their average annual returns over a lifetime of investing to range between 5% and 12%.
This begs the question: which rate of return is more precise? Is it 5%, or could it be closer to 12%?
Determining the exact rate definitively is difficult, but looking at historical data may provide some insight into a more accurate figure.
When deciding between two potential investment options, there are two major factors to contemplate: the assumed rate of return, how it accounts for inflation, and the length of time one intends to invest.
Since investing involves risk, both variables should be carefully evaluated to determine which option may yield the highest returns.
Inflation
The U.S. inflation rate has historically fluctuated between 1.5% and 4%, depending on the year.
So if at any given time you have managed to garner a 10% return on your investments in a year where there was 3% inflation, then your real return or inflation-adjusted profit is more like 7%.
Although this is an oversimplified explanation of the mathematics behind it, the general idea should be clear.
It is essential to remember that inflation is the primary factor that prevents you from simply depositing your money in a bank account and expecting it to grow into wealth.
If the inflation rate is 3%, but you only get a 2% return on your savings, you lose money as your purchasing power diminishes.
Therefore, individuals need to take note of the current inflation levels when investing their money carefully to maximize their financial security.
Investment Period
The length of time you invest will significantly affect the rate of return you expect for various reasons.
Firstly, the longer your investment horizon is, the more aggressive you can be with your asset allocation by weighting it towards stocks and other higher-risk investments, which may yield greater returns.
Additionally, having a prolonged period to invest provides numerous opportunities to buy low and sell high, as well as take advantage of any dips in the market that could result in increased profits over time.
If you are willing to stay invested in the market for a long, you will likely have more good years than bad ones.
This is why it’s essential to remain in the market during times of decline; if you exit, there is a chance that you may miss out on any potential recovery.
Furthermore, the rewards can be much greater with longer-term investments, and significant losses can often be avoided.
Compound Annual Growth Rate For The S&P 500
Over 30 years, between 1960-1989, the average annual return on investment was 10.30%.
After inflation rises, this figure drops to 5.07%. From 1970-1999 that number increased to 13.78%, while in real terms (after accounting for inflation), it was 8.24%.
Finally, from 1980-2009 the average annual return dropped slightly to 11.29%, but when adjusted for inflation, this figure decreased further to 7.52%.
It is important to know that the figures presented are the compound annual growth rate (CAGR), which provides a more precise representation of market returns than simply calculating an annualized average.
This measurement method considers the beginning and ending values and any periodic deposits or withdrawals that may have occurred during the examined period, making it a far more reliable indicator when determining overall performance.
If you have an investment that increases by 100% in one year and then declines by 50% the following year, you would not be making any profit or loss.
However, despite this outcome, the average return over the two years is still reported as 25%, calculated by dividing the difference between both figures (100 -50) by 2.
The Compound Annual Growth Rate (CAGR), which considers the time value of money, would be 0%.
The average inflation-adjusted returns for the S&P 500 over certain 30-year periods range between 5% and 8%.
Therefore, when it comes to retirement planning, taking a rate of return of 6% or 7% is a safe bet.
This figure provides a reliable estimate while accounting for the effects of inflation on investments over an extended period.
Rates Of Return By Asset Class
The return of an asset class is a key factor that should be considered when deciding upon the configuration of asset classes for a portfolio.
Depending on the level of risk tolerance, investors or retirees can choose to invest in various combinations of low-risk assets with high-interest rates, such as bonds, moderate-risk assets, such as stocks, and high-risk assets, such as commodities.
The selection of these different asset classes will determine the portfolio’s overall risk profile.
We will utilize three distinct risk profiles to shape our investment strategy – conservative, moderately conservative, and moderate.
These risk profiles will be determined using data from Charles Schwab, helping us create a tailored portfolio to meet our needs.
With this approach, we can ensure that each of these diverse profiles is adequately represented in our overall plan.
What Is Inflation Risk?
During your retirement years, your money may not go as far as it did when you initially retired.
This is because of a phenomenon known as inflation, an economic concept whereby the prices of goods and services rise gradually over time.
As a result, the purchasing power of your funds will diminish, making it difficult to purchase items that have become increasingly expensive due to this process.
The Bureau of Labor Statistics’ inflation calculator allows you to calculate the purchasing power of your money over time according to historical inflation rates.
With this tool, you can explore how far your money could stretch from one year to the next, giving you a better understanding of the value of your currency relative to inflation.
Even though a calculator cannot accurately forecast what will happen in the future, it can be beneficial to gain insight into how much money has been worth when attempting to calculate how much retirement income you are likely to require in the years ahead.
Doing this can build a more realistic picture of your financial needs and plan accordingly.
Understanding What Inflation Rate You Should Use
Deciding what inflation rate to use when estimating how much retirement spending you will use is tricky.
It’s important to be realistic so that you don’t over- or underestimate the amount of money you’ll need.
The assumed rate of return is another critical factor in this calculation.
If your expected rate of return is lower, you’ll need to save more money.
Conversely, if your expected rate of return is higher, you can afford to save less.
Of course, there are a lot of other factors to consider when planning for retirement, but these are some of the most important.
