One component that is essential to account for in any financial plan is an inflation rate. As we are currently experiencing, inflation considerably above historical norms can really take a bite out of your budget. However, unusually high inflation rates are typically temporary, lasting one to three years, so when planning for decades into the future how much of a difference does an inflation rate really make in the grand scheme of things? The short answer - it makes a tremendous difference. It also provides a terrific way to stress test your financial plan.
Since the rate of inflation varies from year to year, financial advisers often suggest using an inflation rate of 3% to build in a reasonable margin of error. The current historical rate, over the past 20 years, is approximately 2.48%. 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 (such as 8% inflation in 2022 and the current inflation rate of ~6%), but you also want to keep in mind that your intent is to average a realistic rate over a long period of time, not to reflect or emphasize a few outlier years. You don't need to go to extremes. Even with inflation rising to ~8% over 2021 and 2022, that increased the 20 year average inflation rate by ~.33%. A solid amount, but probably not as much as you might have expected. Not to mention that while this increase pushed the historical inflation rate up to the current 2.48%, that average will likely decrease over the next few years as inflation begins to subside, having less of an impact over time. Be careful to see the forest for the trees.
Using the current historical average of ~2.5% may be a good starting point for a financial plan, and 3% should provide
a good margin of error over the long-term, but using a rate of 4% (especially over several decades) may be excessive. It's also important to remember that not all expenses rise at the rate of inflation, and some might not rise at all.
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 $75,000/year, with your mortgage being $21,000 of that total ($1,750/month), and inflation rises by 2.5%, your expenses for the next year would not rise by $1,875 ($75,000 x 2.5%). The increase would be closer to $1,350 since the mortgage does not adjust with inflation. Auto loan and other fixed rate loan payments also do not increase with inflation. You may not have a mortgage or loan payments in retirement, but the point is still valid, not all expenses are uniformly affected by inflation.
Of course, in retirement inflation affects not only actual expenses, but it can also affect the amount you may need to withdraw from tax deferred retirement savings to pay those expenses. Increasing expenses can lead to larger withdrawals, which can lead to higher taxes. For a typical retirement period of 25 years, depending on your expenses and needed withdrawals from retirement savings, a .25% rate increase could easily cost you an additional ~ $200,000, or more. Put another way, each .25% increase in inflation could represent an additional 8%-10% increase in your total expenses. If you choose too high a rate for your plan, 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 to stress-test the outcome. If your savings last until age 90 using a 2.5% inflation rate, that's a solid start. If you fall short at 2.5%, you'll probably want to make some adjustments in other areas to provide a more secure result. If you're still okay using a 3% inflation rate, you have a good amount of risk built in (only once in the the past 30 years has inflation averaged more than 3% for any 5 year period). Once you can see the extent of the impact on your results, it will be easier to decide what action to take, if any. 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. 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.