Inflation And Your Retirement Plan - A .25% Rate Increase Can Equal 25 Years Of Health Care Costs.

One component that all retirement planning tools (even calculators) have in common is that they use an inflation rate as a factor. Some allow you to enter your own rate (highly recommended), and some assume a rate for you (be careful - one "planner" on a very reputable site assumed an 8% annual rate!). The question is - how much of a difference does an inflation rate really make in the grand scheme of things? How much will it affect the amount that you need to save for retirement? The short answer - it makes a tremendous difference.

Financial advisers often suggest using an annual inflation rate of 3.0% - 3.5%. I've seen calculators that assume a rate between 4% (excessive) and 8% (ridiculous). The historical rate, over the past 20 years, is approximately 2.06%. It's 1.74% over the past 10 years. So what rate should you use for retirement planning purposes, 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 (which is always). You want to protect yourself in the event of an unexpected result. No one wants to be in their 80's, or even 70's, and suddenly realize that they might run out of money because they planned too optimistically and/or forgot an important factor in the planning process. That said, you also don't need to go to extremes. In my opinion, using a rate of 4% would be excessive (given the historical context), 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. Inflation is a hot topic at the moment, and the rate for 2021 may be a good bit higher than past years, but be careful to see the forest for the trees - even a couple of anomalies will not have a great affect over a 20-25 year time period (retirement).

More importantly, remember that not all expenses rise at the rate of inflation, and some might not be affected at all, which is why using a rate of 3% may be a little too conservative (at least to start with). 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 ($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 might be closer to $875 since your mortgage does not adjust with inflation. That's a $112,000 difference over the course of retirement. You may not have a mortgage in retirement, but the point is still valid, not all expenses are uniformly affected by inflation.

Of course, inflation affects not only your actual expenses, but also the increased amount that you may need to withdraw from savings each year (in retirement) to pay those expenses. Then, the increased withdrawals, if they are from tax-deferred savings (e.g. 401k/IRA funds), may also increase your tax liability. This can all add up to a significant, and unexpected, amount of money. Over a typical retirement period of 25 years, a simple .25% change in the inflation rate could easily cost you an additional $150,000. That's equal to many projections for health care costs (for an individual) for the same time-frame. The specific amount will depend on your unique circumstances, but you need to be prepared. If you choose too high of an inflation rate, you run the risk of trying to save much more than you may need. Choose a rate that ends up being too low and you could end up with much less money than you planned on.

The best way to approach this is to create your retirement plan, and then try using inflation rates that are .25% apart to stress-test the outcome. If your money lasts at least until age 90 with 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 will 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 results, it will be easier to decide what action to take. Using an adequate inflation rate to try to account for ever-increasing expenses is an integral part of any retirement plan, and it should not be underestimated. Expect what seems to be historically reasonable, but be prepared for something worse.

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