Inflation and Retirement Planning

According to some financial advisors, people who are planning for retirement should compute their average yearly expenses, then save 25 times that amount.  By withdrawing 4% of the total nest egg every year, a retiree can expect that his or her savings will last at least twenty five years.  For a person planning to retire at 65, this means their savings would last until they turned 90.  If invested well, this nest egg could last indefinitely.

Unfortunately, there is a big flaw with this simple calculation.  Inflation, while typically not noticeable year to year, can drastically increase the cost of goods and services over a long period such as 25 years.  The historical average inflation rate of 2% for example, means that a \$1 loaf of bread will cost \$1.02 the following year.  Over twenty five years, however, that loaf of bread would have doubled in price to \$2.  For people who are planning to live only on their savings in retirement, this means that in order to have the same standard of living for every year in retirement, one would need to save a lot more money.

If you’re in the middle of retirement planning, making sure your money will last you through years of inflation can be a complicated calculation.  In addition to having to estimate your expenses over the next 20 or 30 years of your life, you will also need to predict the inflation rate.  To make it even more complicated, there are several different types of inflation.  The government inflation index looks at the total cost of every item for sale in the nation.  The consumer price index, however, excludes the costs of food and gasoline because of the extreme volatility of these prices.

Therefore, many retirees choose to base their calculations on the overall inflation rate when trying to determine how much to save and withdraw.  Unfortunately, Social Security and many pension programs (including those many federal and state employees) are tied to the Consumer Price Index.  This means that the income that many seniors receive will not keep up with rising prices.  When saving for retirement, this means that seniors will need to make up for this shortfall with their own savings.  Recently, the government refused to increase the amount of Social Security checks for the past two years.  Although the last two years have seen large spikes in the cost of basic staples such as food and gas, retirees have been on their own to make up for the inflation in these areas.