Inflation Does Not Affect All Expenses Equally

One component that all financial planning tools (even calculators) have in common is that they use an inflation rate as a factor. Some allow you to enter a rate, some assume a rate for you. But how much of a difference does that rate really make in the grand scheme of things? The short answer - it makes a tremendous difference.

Financial advisers often suggest using an inflation rate of 3%. I've seen calculators that assume a rate of 4%. The historical rate, over the past 20 years, is approximately 2.16%. So what rate should you use, and how much difference does a small adjustment make? It's always best to be conservative when you can't reliably predict what will happen in the future. You want to protect yourself in the event of an unexpected result. That said, you also don't need to go to extremes. In my opinion, using a rate of 4% would be excessive, 3% may be overly conservative, and 2.5% may be a good starting point. The actual inflation rate changes from year to year, so you want to strive to hit a median amount over a long period of time. Also, remember that not all expenses rise at the rate of inflation, and some might not rise at all, which is why a rate of 3% may be a little too conservative. For example, a fixed rate mortgage payment will not change from year to year, and that could easily represent 25% - 33% of your total expenses. If your expenses are $50,000/year, with your mortgage being $15,000 of that total ($1,250/month), and inflation rises by 2.5%, your expenses for the next year would not rise by $1,250 ($50,000 x 2.5%). The increase would be closer to $875 since the mortgage does not adjust with inflation.

Of course, inflation affects not only the actual expenses, but also the amount you may need to withdraw from tax deferred retirement accounts to pay those expenses. Increasing expenses leads to larger withdrawals, which can lead to higher taxes. When choosing an inflation rate to use for a typical retirement period of 25 years, a .25% difference could easily represent  ~$200,000 in the total amount of money that you will need to save. If you choose too high a rate, you run the risk of trying to save much more than you may need, and vice versa. Individual circumstances will ultimately decide how much of a difference the rate makes, but a small difference in the rate can certainly have a significant impact on your savings goals.

The best way to approach this is to create your retirement plan, and then try using inflation rates that are .25% apart. If your money lasts until age 90 at 2.5% inflation, that's a solid start. If you're still okay at 3% inflation, you have a good amount of risk built in. If you fall short at 2.5%, you'll probably want to make some adjustments in other areas to provide a more secure result. Once you can see the extent of the impact on your unique results, it will be easier to decide what action to take. This is yet another good reason to choose a retirement planning tool that's capable of accurately calculating which of your expenses are subject to inflation, and that offers the flexibility, detail, and clarity to help with this process.

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