Using Inflation and Life Expectancy Assumptions for Retirement Planning
Retirement planning requires that you look into the future to determine how much money you should save today to account for future inflation and your life expectancy. Most people don't have a crystal ball to see into the future. So, no one truly knows what inflation will be or exactly how long they need their money to last.
However, there are retirement planning steps you can take now that will help you plan as well as you can for tomorrow. As every situation is unique, it requires using historical comparisons and rules of thumb.
Run Best and Worst-Case Examples
Variables like your rate of return on investments, life expectancy, inflation and your willingness to spend principal will all have a giant impact on the amount of money you calculate that you will need to retire.
To show the impact these variables have, you will want to develop the best case and worst case example, such as what you see below. In the examples below the answers are determined by using the assistance of spreadsheets and retirement planning software. An online retirement income calculator can help you run a similar analysis.
Inflation and Life Expectancy
Inflation is the measurement of what a dollar will buy at a given period. Most often you will see inflation spoken about as it relates to the Consumer Price Index (CPI). The CPI is a standard basket of goods that economist determine nearly all people will need. Historically, inflation runs between 1.5% and 4% each year. When inflation is high, your dollar bill does not buy as much as it will when inflation is low.
Life expectancy is the measurement of the average number of years a person will live. Many factors go into determining this number such as the part of the world in which you live and your socio-economic level. According to the United Nations (U.N.), the global life expectancy at birth for the entire population is 72.28 years.
Best Case Example
Let's assume you need $50,000 per year to spend above and beyond your guaranteed sources of income. Guaranteed sources of retirement income include funds from Social Security and Guaranteed Retirement Accounts (GRAs).
Below are the remaining best-case assumptions:
- 2% inflation rate
- 25-year life expectancy
- 7% inflation-adjusted return on investments
- Okay to spend principal down to nothing
The software tells us that you will need almost exactly $700,000 to provide this $50,000 per year of inflation-adjusted income for 25 years. An inflation-adjusted return—also known as the real rate of return—removes the effect of inflation, taxes, and other expenses. It gives you an idea of the potential return without the influence of external forces.
Worst Case Example
Again, let's assume you need $50,000 per year above and beyond your guaranteed sources of income. Below are the remaining worst-case assumptions:
- 4% inflation rate
- 35-year life expectancy
- 5% inflation-adjusted return on investments
- You want to retain $700k of principal to pass along to your heirs
Now the software says you will need $1.8 million to provide that same $50,000 per year of inflation-adjusted income for 35 years. Also, notice a big factor here is that you do not plan to use your retirement funds down to zero but pass them on to your beneficiaries.
How Much Money Will You Need to Retire?
Retirement planning is not an exact science when determining how much you will need in your total retirement savings. The answer in the example above is likely somewhere between $700k and $1.8 million. If real-life throws a set of circumstances at you that are worse than the worst-case scenario, maybe even more.
Since you don't know what inflation will be in retirement, what your rate of return will be, or how long you will live, you can't come up with an exact answer. The next best thing is to come up with a reasonable set of assumptions and make sure you re-evaluate every few years.
To help you determine the right assumptions to use, and to accurately factor in tax consequences, you may want to seek the assistance of a qualified retirement planner and take the time to read several books on retirement planning.
The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.