Factor In Inflation Today, Enjoy Financial Independence Tomorrow

When it comes to building your retirement nest egg, a common rule of thumb is to save 25 times your annual expenses and then spend no more than 4% of your savings every year in retirement.  The thought is, if you retire at or near normal retirement age, this strategy should allow your retirement savings to carry you through retirement.  Sounds simple, right?

Not so fast!  Inflation can eat away at your retirement budget and leave you underfunded if you don’t factor inflation into your budget.

Let’s say you are 25 years old, and want to retire on a $40,000 per year withdraw in retirement at age 60.  According to this rule of thumb, you will need $1 million dollars to withdraw $40,000 per year.

There’s one problem:  are you prepared to live on what $40,000 will buy you in 2053, or did you actually want to live off of what $40,000 will buy you today?   With some additional legwork, you can adjust your savings target for inflation and better prepare yourself for financial independence.

Factoring Inflation

Inflation is a retirement savings carnivore – it eats away at your investment returns, leaving you less real dollars to spend because the cost of everything else in life has gone up.

From 1957-2018, inflation has ranged from 1% to 12.4% annually.

(Source:  United States Dept. of Labor Statistics)

As you can see in the chart above, over the last 25 years we have enjoyed inflation in a stabilized range at or below approximately 3%, with an average annual inflation rate of 2.17%.

(Source:  United States Dept. of Labor Statistics)

The Impact Of Inflation On Saving 25 Times Your Annual Expenses For Retirement

There is a huge difference between saving 25 times your projected annual expenses in today’s dollars, versus your retirement budget’s inflationary dollars.

Let’s look at how inflation would impact our future retirees, and the amount they will need to save to in 2018 dollars to meet 25 times their expenses:

Emma is a 35 year-old partner at a major law firm in New York.  She works hard and treats herself to exotic vacations and spending sprees at  luxury department stores when she can get away from the office.  She is just starting to save for retirement after tackling her student loans, and can’t imagine ever slowing down and needs at least $100,000 per year in retirement, even after paying off the house and her student loans.

Emma needs to save $2,500,000 ($100,000 x 25).

Mike is a 25 year-old engineer who wants to save enough to make sure he doesn’t have to work a day over 60, and sooner if he can afford it.  Mike can easily live off of $40,000 per year in retirement with no mortgage or other loans to account for.

Mike needs to save $1,000,000 ($40,000 x 25)

However, if Emma and Mike fail to factor in inflation, they will have far less to spend than they anticipated.

In order to calculate retirement savings that will more likely to cover 25 times their annual expenses future dollars, Emma and Mike need to take into consideration inflation and adjust their savings target accordingly to reach their Inflation Adjusted FI Number.

Applying An Inflation Adjustment To Their Retirement Goals

Once you have your savings target in today’s dollars, run that number through an inflation calculator to determine your Inflation Adjusted FI Number.

Once such calculator can be found at Calculator.Net:  (note:  I have no affiliate relationship with Calculator.Net).

Adjusting Emma’s need for $2,500,000 in 25 years, and Mike’s need for $1,000,000 in 35 years for inflation, we see that both Emma and Mike will need to save substantially more to reach their Inflation Adjusted FI Number by age 60.  (Note:  For illustrative purposes for the sake of this exercise only, I used 2.2% as the average rate of inflation over the next 25 years).

Emma’s Inflation Adjusted FI Number

In order to have the spending power of $2,500,000 in 2043, at 2.2% inflation, Emma will need to save approximately $4,307,372.


Otherwise, she will be deeply disappointed if she truly wanted to be able withdraw $100,000 per year and not exceed a 4% withdrawal of her retirement accounts.  At 2.2% inflation, $100,000 per year in 2043 is the equivalent of living off of roughly $58,000 per year today.

On the flip side, Emma will need $172,295 per year to live off of the equivalent of $100,000 per year.

If Emma saved $2,500,000 by age 60 as she originally planned and continued to live off of the equivalent of $100,000 per year ($172,295) at 2.2% inflation, she would have only saved 14.5 years of her projected retirement expenses, not 25.  ($2,500,000 / $172,295 = 14.5).

It looks like Emma’s plans to keep living it up in retirement at the same pace she is living today are going to need a major wake up call without some changes.  She will either have to make a lifestyle change in retirement, or risk running out of money.   No more caviar!

Mike’s Inflation Adjusted FI Number

Going through the same calculations, Mike will need $2,141,812 at 2.2% inflation in 2053 to have the spending power that $1,000,000 would provide in today’s dollars.

This is because it will take $85,672 in 2053 to cover the same expenses that $40,000 would cover today.  Meanwhile, $40,000 will only cover the equivalent of $18,676 in 2053.

If Mike saved $1,000,000 by age 60 as he originally planned, he would have only saved 11.7 years of his projected annual expenses for retirement, not 25.  ($1,000,000 / $85,672 = 11.7).

Adjusting Your Retirement Savings

No one can predict what the exact rate of inflation will be in the future.  However, by calculating an Inflation Adjusted FI Number and then adjusting your retirement savings to meet it, you can help make sure that inflation doesn’t prevent you from reaching financial independence.

(Updated on 9/8/18)

Once you reach your Inflation Adjusted FI Number, you can sit back and let the 4% rule carry you through retirement!

6 Replies to “Factor In Inflation Today, Enjoy Financial Independence Tomorrow”

  1. I’m pretty sure the 4% rule already factored in inflation. You withdraw 4% the first year and add the inflation rate to the withdrawal every year. In previous decades, the investment gains will offset the inflation. That’s the beauty of the 4% rule. It’s an easy guideline.
    However, we don’t know if this will hold true in the future. The stock market might not gain enough to offset inflation.
    ps. Thanks for using my affiliate link! 😉

    1. Thanks for your comment! You are right that the 4% rule factors in inflation once you have already reached retirement age.

      I’m hoping my post will help savers still looking to reach their FI number adjust the 25x number they seek accordingly to give them the spending power they want in today’s dollars when they get to their retirement age.

      For example, someone planning to retire in 15 years can set an inflation adjusted goal that will allow them to live off the equivalent of $50,000 per year today, in the year 2033’s dollars.

      It’s much easier to save a little bit more now, than realize too late that you haven’t saved enough and need to work a few more years to be able to save 25x the expenses you have in 2033!

  2. I read the post and came to the same conclusion as Joe did (he beat me to the punch. lol).

    But yeah if you save 25x your expected annual expense by putting it under a mattress the scenario you describe rings true.

    But if it is invested similar to the Trinity study which came up with the 4% rule (I believe the study was based on 60/40 equity/bond split) the inflation that occurs will be offset by the market performance.

    By the way love the name of your blog and how it ties to your profession and finance.

    1. Thanks for stopping by and the comment Xrayvsn! What I hoped to convey is setting an appropriate FI target which makes sense for what your likely expenses will be in the future. If someone doesn’t factor inflation into that target number, they might end up having to work longer or live off of less than they anticipated when they reach retirement age.

      For example, what if you save X dollars a year for 20 years with the goal of a $2.5M nest egg, but you realize 15 years into it that you really should have been trying to save $4M to continue the lifestyle you want to maintain in retirement?

      I agree that once you reach a number that you can comfortably life off of 4% a year, you should be set as long as that money is invested.

      Xrayvsn is an awesome name for a blog for your profession.

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