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.
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!