If you’re planning for retirement, you need to know if you will have enough money to maintain your lifestyle and cover your necessary health care expenses as long as you shall live.
That’s where nominal income versus real income comes in. You may not know the terms, but they are relevant to how you plan for retirement.
You need to know what your dollars will be worth in real terms; meaning what amount of goods and services can they purchase.
For example, if you have enough money to buy a loaf of bread and pay your health insurance premium today, you also want to know you’ll have enough money to buy a loaf of bread and pay your health insurance premium in 15 years—even if the price of these items has increased. That is referred to as “real” dollars. They are real because they buy the same amount of goods and services—which is what you need them to do.
To understand nominal dollars, imagine that I hand you a $10 bill today. You put it in a drawer and pull it out 15 years from now. It is still 10 dollars in nominal terms; meaning its face value is $10. But will it buy the same amount of bread and health insurance that it did 15 years ago? Unlikely. That means in real terms it is not worth the same amount as $10 is worth today.
In retirement, what you need are real dollars. If you knew how the prices of your needed products and services would rise or fall, that would be relatively easy to calculate. Since there is no way to know, you have to make an educated estimate. An inflation rate of 3% or 4% is the standard amount used.
Rates of Return
You must also estimate the rate of return your savings and investments will earn. Suppose you invest conservatively and assume your savings and investments will earn about 3% a year. Assuming prices rise by about 3% a year, what is your real return?
It is zero. Your investments will be going up in value at 3% a year, but if inflation is also 3% each year, they will purchase the same amount of goods and services as they did before. It, by the way, is an acceptable outcome.
Now, assume your savings and investments earn 5% a year, while inflation is 3%. What is your real rate of return? It is 2%. Your savings and investments go up each year, and they purchase more goods and services than they would have the year before.
Real Sources of Retirement Income
Social Security has a cost of living adjustment built into it, and the adjustment is made annually depending on the previous year’s inflation measure. That means if you start off receiving $1,000 of Social Security, then in 20 years that $1,000 should still buy about the same amount of goods and services that it was able to purchase initially. One thousand dollars of Social Security income represents $1,000 of real income.
If you work part-time in retirement, that may also provide you with a source of real income as wages often increase with inflation.
Nominal Sources of Retirement Income
Most pensions do not have cost of living increases so they will provide nominal dollars to you. That means for every $1,000 of pension income you receive, 20 years from now it will buy fewer goods and services than it did initially.
Any guaranteed fixed source of retirement income will provide nominal dollars unless it contractually offers a cost-of-living adjustment.
Some annuities offer inflation-adjusted payouts. It takes more capital to buy an annuity that provides a payout that will increase with inflation (real dollars) than to buy one that offers a fixed monthly payment (nominal dollars). It may not be worth it as it will give you less income early on in retirement, and more income later when you are less likely to need it. Much retirement spending research shows that later in life people go out less, shop less, and travel less, and as these things occur less, this income can be re-directed to offset rising prices in other areas.
The downside is that although you will incur less expense from dining, travel, shopping, etc., you will likely take on more healthcare expense. Because none of us know what life will look like in the future, responsible financial planning means saving money to cover these unknowns. Talk with a financial planner to put together detailed projections of what retirement will look like or if you're already retired, how much you're able to comfortably spend and still make ends meet in the later years of retirement.
It is good to have real income, but not all your retirement income needs to increase with inflation. The important thing to do is be consistent in how you do your planning and remember that $10,000 twenty years from now is not worth the same as $10,000 today.