How to adjust for inflation in retirement planning?

[jadela]

I'm writing my IPS (https://www.bogleheads.org/wiki/Investm ... _statement) and have a question about planning for inflation.

To get $2M in today's dollars in 27 years, it seems like I need to:
(1) adjust the rate of return to be real instead of nominal, or
(2) adjust my target end balance to scale it up for inflation

Do I need to do both?


EXAMPLE
Approach (1)
I have a current portfolio value of ~$230K. To grow this to $2M in 27 years needs a 8.34% CAGR. If this was a real rate of return instead of nominal, then it seems the future value also be inflation-adjusted.


Approach (2)
Let's say I want to have $2M in today's dollars at retirement in 27 years. Adjusting for inflation (assumed @ 3%), that would be...

PV(1+r)^n = FV
2,000,000(1.03)^27 = $4,442,578
To get there in 27 years from a starting point of $230K would be a 11.59% CAGR.

Looking at these two examples, it seems like I need to do one or the other, but not both, but I want to check with the community here. Seems that the difference in the required rates of return is the rate of inflation.

Is that the correct conclusion?

[MathWizard]

Definitely do things in real (inflation adjusted) terms.
The real return of investments tends to be more stable than the nominal.

Then adjust those things that do not track with the normal inflation which is quoted.

Health Care:
A retirement advisor suggested health care costs adjusted at 2% above normal inflation,
so just use real investment returns and adjust just the health care costs at a 2% inflation rate.
Health care is likely to be one of your highest costs if you have a paid off house and no
children as dependents in retirement.

Pensions or annuities that are not inflation adjusted.
These should be adjusted down, since the payments become less in real terms as time goes by.
You could use NPV. For us, this is just a small amount, so I just multiply the value by 70% and call it good.
My other estimates are probably only accurate to with 10% (if I am lucky).

[Triple digit golfer]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

[lakpr]

I simply subtract 3% from the nominal returns, I always use 5% as real-returns in my assumptions for stock market returns. $230k, at 5% real-returns, in 27 years, will grow to $859k.

$230k starting balance plus $19k annual contributions, at that 5%, will grow to $1.9 million.

[jadela]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

[rockthisworld]

I only use in real terms. I assume 1.5 real. So if long term inflation is 3.5% I would use 5% nominal.

[decapod10]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

That would be 8.3% real return. Anytime you're making calculations in "today's dollars", you're probably using real return. Your nominal return will need to be higher (roughly 8.3% + inflation) in order to produce $2M in "today's dollars" in 2047, unless there is deflation.

I usually use the short hand equation which is: real return = nominal return - inflation

Although the actual equation is real return = ((1 + nominal rate)/(1+inflation)) - 1

Anyway, ignoring that and just using the shorthand equation. say inflation is 3%, and you get 8.3% nominal return, then $230k will become $2M (nominal dollars) in 27 years. However, clearly with a 3% inflation rate, $2M in nominal dollars in 2047 is going to be worth less than $2M in 2020 dollars in 2047. You actually need about 11.3% nominal return (8.3% + 3% inflation). In 2047 at 11.3% nominal, you would have $4.14M in 2047 dollars, which should be roughly worth $2M in 2020 dollars (in 2047).

Edit: looking at your original post, your calculations look roughly correct.

[averagedude]

I have been retirement planning since my mid 20's. I have always used real returns in today's dollars. In my opinion, this is the correct way to plan, and it is also easier to comprehend the numbers.

[jadela]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

That would be 8.3% real return. Anytime you're making calculations in "today's dollars", you're probably using real return. Your nominal return will need to be higher (roughly 8.3% + inflation) in order to produce $2M in "today's dollars" in 2047, unless there is deflation.

I usually use the short hand equation which is: real return = nominal return - inflation

Although the actual equation is real return = ((1 + nominal rate)/(1+inflation)) - 1

Anyway, ignoring that and just using the shorthand equation. say inflation is 3%, and you get 8.3% nominal return, then $230k will become $2M (nominal dollars) in 27 years. However, clearly with a 3% inflation rate, $2M in nominal dollars in 2047 is going to be worth less than $2M in 2020 dollars in 2047. You actually need about 11.3% nominal return (8.3% + 3% inflation). In 2047 at 11.3% nominal, you would have $4.14M in 2047 dollars, which should be roughly worth $2M in 2020 dollars (in 2047).

Edit: looking at your original post, your calculations look roughly correct.

Got it. So it sounds like when I'm using various formulas / calculators, that:

- if I'm using today's dollars to calculate, then the resulting return needed is real (8.34% in my OP, example 1)
- if I'm calculating using future dollars, then the resulting return needed is nominal (11.59% in my OP, example 2), which implies an underlying real rate after inflation

[bogle707]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

I believe what "Triple digit golfer" is saying is that you can just use your current annual expenses, for example $50k/yr, and using the 4% rule come up with a FIRE target of $1.25 million. Now you must take the $230k present value of your investments, estimate your real return (Real Return = Nominal Return - Inflation), and plug that into a future value calculation (adding in annual investments as appropriate). You can just do this in excel and iterate your time (years) until you get $1.25 million. Since you already discounted your nominal return (CAGR) by inflation, this is the same thing as taking Nominal Return and adding inflation into your future value calc for expenses. So yes, you either account for inflation in your expenses and use nominal return, or you use today's dollars for expenses and account for inflation by using real returns for your investments.

One thing to note, as others already have, is that things don't always inflate by a single value. So I like to actually account for inflation in my expenses, and use different inflation values (for example 2% for property taxes), and whatever the CPI rate is for my area for everything else (3-3.5%). You can take this approach with health care, college tuition (I was told this is a crazy 6% inflation rate), etc.

Can someone check my work?

[fatcoffeedrinker]

Deleted

[Triple digit golfer]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

It would mean you need an 8.34% real return. 11.59% nominal.

[bogle707]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

It would mean you need an 8.34% real return. 11.59% nominal.

Which is a crazy high number to use when planning for FIRE. I would use 5% (real return), which means you need closer to 45 years. But this is obviously assuming no other contributions to your investment accounts. If you invested around $20k/yr ($1667/month), you would hit your mark in 27 years (assuming 5% real return).

[Triple digit golfer]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

It would mean you need an 8.34% real return. 11.59% nominal.

Which is a crazy high number to use when planning for FIRE. I would use 5% (real return), which means you need closer to 45 years. But this is obviously assuming no other contributions to your investment accounts. If you invested around $20k/yr ($1667/month), you would hit your mark in 27 years (assuming 5% real return).

I am using 3% real for my 80/20 portfolio for 20 years. I think even 5% may be high.

[bogle707]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

It would mean you need an 8.34% real return. 11.59% nominal.

Which is a crazy high number to use when planning for FIRE. I would use 5% (real return), which means you need closer to 45 years. But this is obviously assuming no other contributions to your investment accounts. If you invested around $20k/yr ($1667/month), you would hit your mark in 27 years (assuming 5% real return).

I am using 3% real for my 80/20 portfolio for 20 years. I think even 5% may be high.

I don't disagree. Anything above 5% is too high.

[Nowizard]

Our approach is pragmatic and not particularly analytical but simple. Our goal is to maintain principal after annual expenses which in a sense could be considered to be saving for our heirs. Additionally, we look at our overall portfolio percentiles compared to the average benchmarks related to all funds we own (Five). That is one comparison that allows us to determine how we are doing in terms of benchmarks as opposed to increase or decrease of portfolio totals. In times like these, we say that sometimes you make the most by losing the least.

We are fortunate in that we have SS and a relatively small pension that meet approximately 65% of our expenses annually. We enter our portfolio totals into a web site (Morningstar) on January 1 of each year and add or subtract as distributions and expenditures occur. That gives a percentage of change whether positive or negative YTD at any point in time. Investigation has revealed that inflation has averaged 2.36% over approximately the last 20 years, so we take our totals on January 1 of each year and add 2.36% to determine our investment goal for the upcoming year. The following year, that amount, not the actual portfolio amount, is increased by 2.36% to establish that goal. At this point, for example, we have a paper loss for 2020 of approximately 5%, but based on the figures above, we have a small excess of having already added 2.36% to the portfolio total for 2020 based on 2019 which substantially exceeded 2.36% in returns. So, though paper losses have occurred due to the current environment, we are doing fine based on investment goals and inflation.
I'm sure there are many other ways that involve substantially greater technical analysis to determine goals, but it works for us and has allowed us to move from a 60/40 stock/bond ratio to our current 37/63 ration currently.

Tim

[NBKCF]

Off topic-ish, but I think this might help answer my question regarding real/nominal.

When I review my portfolio's performance on Fidelity in 2019 I see a growth of 23.66%. This growth is (2019 Ending Value - 2019 Beginning Value - 2019 Contributions)/(2019 Beginning Value). This return is considered the Nominal Return, correct? The Real Return would be 23.66% minus the 2019 inflation rate, correct?

[JBTX]

Off topic-ish, but I think this might help answer my question regarding real/nominal.

When I review my portfolio's performance on Fidelity in 2019 I see a growth of 23.66%. This growth is (2019 Ending Value - 2019 Beginning Value - 2019 Contributions)/(2019 Beginning Value). This return is considered the Nominal Return, correct? The Real Return would be 23.66% minus the 2019 inflation rate, correct?

Yes.

[dbr]

It becomes more complicated when some income items or expense items are fixed in nominal dollars and others are fixed in real dollars. Examples of fixed in nominal dollars are many pensions and also paying off a mortgage. Planning models (example FireCalc) allow income and/or expenses that are eithr inflation indexed or fixed in nominal terms. With any of these complications you have to take explicit account of inflation one place or another. The real world can be a little more complicated than a simple 4% model however you allow for inflation.

The answer to your original question is either one of the calculations would work but you don't do both.

[GAAP]

Using real terms requires a single net estimate. Variability in returns and inflation are more likely to partially cancel each other out.

Using nominal terms requires two estimates that are then multiplied to create a real estimate. This is far more likely to be way off the mark.

You need a real result to meaningfully understand the implications of your planning -- using real numbers from the start is generally a better idea.

[jadela]

[Thread merged into here --admin LadyGeek]

When projecting future value in a portfolio, it's in todays dollars right?

i.e. FV = PV (1+r)^n

I think FV is in current dollars, and is not inflation-adjusted.

Is this ok for planning purposes--or what are my future income and portfolio needs--or do I need to adjust for inflation somehow?

[FiveK]

Depends on whether "r" is a "nominal" (includes everything, including inflation) or a "real" return (everything minus inflation).

Using real returns so the results are in today's dollars is usually preferable.

See also Real vs nominal rate of return that says the same thing but perhaps in different words.

[jadela]

Ok, thanks. Want to make sure I'm getting this right.

So if in my IPS I want to withdraw $100k / year and assume a 3.5% SWR, that would imply a portfolio balance of $2857142.

If my current balance is $328k, that means my gap needed for that goal is $2,529,143.

I'm a little confused about whether to use nominal or real projected CAGRs here to figure out what level of risk / return I need to take to hit that goal.

I think it's like this...

That starting balance projected forward 25 years at a 9% CAGR says FV of $2.828M. I'm picking 9% as the total nominal return rate for a pretty aggressive portfolio. Which would cover my goal. is that right? Or do I need to plan it with a real rate of return (subtracting inflation, so something like 6%) for it to work as I'm intending. What I want is the FV that would let me withdraw the equivalent of $100k/year (in today's dollars) assuming a 3.5% withdrawal rate.

[Valuethinker]

Ok, thanks. Want to make sure I'm getting this right.

So if in my IPS I want to withdraw $100k / year and assume a 3.5% SWR, that would imply a portfolio balance of $2857142.

If my current balance is $328k, that means my gap needed for that goal is $2,529,143.

I'm a little confused about whether to use nominal or real projected CAGRs here to figure out what level of risk / return I need to take to hit that goal.

I think it's like this...

That starting balance projected forward 25 years at a 9% CAGR says FV of $2.828M. I'm picking 9% as the total nominal return rate for a pretty aggressive portfolio. Which would cover my goal. is that right? Or do I need to plan it with a real rate of return (subtracting inflation, so something like 6%) for it to work as I'm intending. What I want is the FV that would let me withdraw the equivalent of $100k/year (in today's dollars) assuming a 3.5% withdrawal rate.

So if you are locked on $100k pa then that's a real number.

So you should use real returns. 6% real is a long run average for US stocks but for a number of reasons I believe 3-5% pa is a more reasonable guess at the next 30 years.

So 100k in 25 years / 4% = $2.5m in today's money (sorry I don't have a calculator to hand what it is if /3.5%)

So using real rates of return, you need a portfolio of $2.5m in today's money (somewhat more since you are using 3.5%).

My caution would be that you are combining a quite high SWR with high equity returns - so you are really rolling the dice and you need a plan b if returns don't meet your expectations.

If you were using nominal returns you would have to discount your future withdrawal by x 1/(1+inflation rate)^years to get it equal to $100k in current dollars. For long periods of time it is generally easier to work in real numbers (ie today's/ constant dollars). Saves having to forecast inflation.

[jadela]

Got it. Thank you! Real return it is.

[jadela]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

It would mean you need an 8.34% real return. 11.59% nominal.

Which is a crazy high number to use when planning for FIRE. I would use 5% (real return), which means you need closer to 45 years. But this is obviously assuming no other contributions to your investment accounts. If you invested around $20k/yr ($1667/month), you would hit your mark in 27 years (assuming 5% real return).

I understand how to model the FV with a lump sum. How do you model this / what is the math for projecting FV with these additional contributions (e.g. $20k/year, DCA'd monthly)?

[LadyGeek]

jadela - In order to provide appropriate advice, it's best to keep all the information in one spot. Your second question is related to the first and I have merged the threads. The combined thread is in the Investing - Theory, News & General forum (theory).

(Thanks to the member who reported the post and provided a link to this thread.)

[Valuethinker]

I do everything real, using today's dollars.

If I need $50k a year in today's dollars and want 25x expenses at retirement, I need $1.25 million in today's dollars.

The return required to get there is the real return.

Thanks. So are you saying that either of the two approaches I laid out would work?

I *think* this is what you're saying:
1) I want $2M in today's dollars.
2) Currently, I have $230K.
3) That implies an 8.34% CAGR

What I'm unclear on: does this mean I need an 8.34% real return, or a 8.34% nominal return? I think you're saying nominal.

It would mean you need an 8.34% real return. 11.59% nominal.

Which is a crazy high number to use when planning for FIRE. I would use 5% (real return), which means you need closer to 45 years. But this is obviously assuming no other contributions to your investment accounts. If you invested around $20k/yr ($1667/month), you would hit your mark in 27 years (assuming 5% real return).

I understand how to model the FV with a lump sum. How do you model this / what is the math for projecting FV with these additional contributions (e.g. $20k/year, DCA'd monthly)?

Save yourself complicated formulas.

Do this on a spreadsheet. Years are the heads of columns.

Rows are

starting principal balance
returns from investment = start * (1+r) where r = % return assumed
contribution at end of year
Closing principal balance = sum of the above

Basically you have a final principal value for each year (investments + returns to date). To which you add $20k (say at the end of each year).

So in year 5 I have $400k, 5% return takes me $420k. Then I add 20k. That additional is another row on the table

My new starting principal is $420k.
To that I apply my 5% return which takes me to $444k.
Then I add another $20k which is $464k
That is my closing balance

For the next year my opening principal balance = closing balance of previous year ie 464k
Then I apply my return of 5% to the 464k
Then I add my 20k
That gives me a new closing balance

And repeat for 25 years. By making the contribution of the $20k at the end of the year, I have taken a maximally conservative view. If for example you can do it at the start of a year, that's a whole another year of returns you've gained (for that contribution).

I would not want to assume more than 5% real. 3% real is adequately conservative in my view. Depends on your bond-equity mix of course. But definitely not more than 5% real.

[jadela]

That makes sense. Thank you!

[22twain]

Any projection 25 years in the future will be only a very crude guess, attempting to select from a wide range of possible outcomes.

To see how well this would have worked in the past, try Firecalc: http://www.firecalc.com/

On the starting page, set your your initial portfolio value and number of years (25), and set the spending rate to zero. On the "Not retired yet?" tab, set your annual contributions in today's dollars. (Firecalc always works in today's dollars.)

You'll see the range of final portfolio values that you would have had after each 25-year period starting in the 1870s, based on historical data for stock and bond returns and inflation rates. The main takeaway is the wide range of possible outcomes, from the same starting values.

Going further, change the starting tab so the number of years includes your hoped-for retirement period, e.g. 55 years for a 30-year retirement, and set your hoped-for spending during retirement (in today's dollars).

You'll now see a set of historical complete accumulation and decumulation trajectories.

In the other tabs you can set your expected Social Security and/or pension, tinker with your portfolio composition, etc.

Obligatory caveat: even if Firecalc shows 100% "success" for your inputs (i.e. you would never have run out of money), this is based on past data. The WORST TIMES EVER may be just around the corner!! Even worse than the Great Depression, or the Great Stagflation of the 1970's!!

[Valuethinker]

That makes sense. Thank you!

Note that the assumption then is your contributions grow at 0% real. Because we are doing this in Real not Nominal terms (ie in current dollar terms). So in the real world you'd be increasing your nominal contributions each year by that year's inflation.

It's best to run this at say:

3% real return
4% real return
5% real return

That will give you a feel for a "safe" withdrawal rate. At 3% real return I doubt you will find an SWR, to age 95, of 3.5%

(although the part of your portfolio that you do not withdraw, will continue to grow at 3% real, say).

There's a pretty strong case that when you do retire you move to a more conservative strategy. Often short-formed here as Sequence of Return Risk (SRR) in case you have a period like we are undergoing right now (bonds and stocks down) early in your retirement years.

So you might only want to assume 3% or even 1% or 2% real returns in retirement.

Don't forget the very long life expectancies of partners - in particular if they are female. I had at one point something like 5 female relatives alive over 90. Women who make it to 65 can live a very long time indeed. Men this is less the case.

Covid aside, it's quite easy to live to be 95 these days (if you are middle class and otherwise in good health). I more or less have to plan for my partner to live to be 100 (the home equity will pay the nursing home fees, I hope). There's also the nightmare scenario where one of you has to go into a home (say due to dementia) and the other is left to maintain a separate household. There's a limit to what I can realistically prepare for - -but again home equity would help.

[Valuethinker]

Obligatory caveat: even if Firecalc shows 100% "success" for your inputs (i.e. you would never have run out of money), this is based on past data. The WORST TIMES EVER may be just around the corner!! Even worse than the Great Depression, or the Great Stagflation of the 1970's!!

Wise warning.

And at their worst, those periods saw something like -50-60% fall in stocks (-80% in the early Great Depression years?). In the Great Depression, deflation meant things looked better (stocks fell but prices also fell, so what was left bought more). In the Great Inflation of the 1970s, the reverse - nominal returns were higher but real returns were lousy, truly lousy (for basically everything but T Bills?).

[FiveK]

I understand how to model the FV with a lump sum. How do you model this / what is the math for projecting FV with these additional contributions (e.g. $20k/year, DCA'd monthly)?

See FV function and/or Time value of money.