We touched on the subject of inflation before in a previous post on benchmarking, but I would like to return to it briefly just to stress how important it is in your planning.
In the short term, inflation can seem harmless enough. If you leave $100 under your mattress and the rate of inflation is 3%, then next year your $100 will buy 3% less goods and services. In other words, in order to buy the same amount of goods and services you now need $103. When you extend this to 10 years you may think that you now need $130, but the effects of compounding mean that you actually need $134.39. Yes, as wonderful as compound interest is when working in your favor, compound inflation, it’s evil twin, is working against you over time.
So how can inflation affect your long term financial planning? Well first of all it will affect the targets you set. Let’s take an example of someone who wants to have an income of $50,000 per year in retirement in 25 years time:
If you can find a miracle low risk product that generates a 10% annual return, then you need $500,000 in capital at retirement. Then you can live off the interest without spending your capital and it doesn’t matter how long you live.
If we are more realistic and think in terms of a 5% return, then you need $1,000,000 in order to generate $50,000 per year.
What if you can only get 2.5% in retirement? Well then you need $2,000,000.
The problem is that all of these numbers are in today’s money. The table above tells us that over 25 years at 3% inflation, our spending power will more than halve. (it actually goes to 46.70% but let’s keep the numbers simple) That means that with a 5% return we actually need $2,000,000. And with a 2.5% return we need $4,000,000.
This is why it’s important to start saving and investing early. If we are not taking advantage of compound interest on our savings, our nest egg will be getting eaten away by its evil twin inflation!