Adjusting for Inflation

In two recent posts, I discussed the necessity of taking inflation into account, and different ways to adopt a reasonable assumption about what inflation will be. (Not a prediction; just an assumption.) I guess it’s time to say something about how you go about doing that.

The easiest way to take inflation into account is to do it implicitly, rather than explicitly. Huh?

What I mean is best illustrated with an example. Let’s re-call Ernie. A couple of posts ago, we figured that Ernie needed to save for a target of $948,750. To arrive at that goal Ernie assumed his long-term rate of return would be 6%. But not really. He was hiding something (the scamp!). What he really assumed was that his nominal long-term rate of return would be 9% and that inflation would be 3%. His real (i.e., inflation-adjusted) rate of return was assumed to be the difference. Is 9% a reasonable assumption for a nominal earnings rate? For the time being, grant me that it is. So Ernie did in fact assume some inflation, but it was implicit, hidden in his 6% real rate of return.

In addition to making his arithmetic easier, using a real rate of return has another advantage. It keeps your numbers real (i.e., inflation-adjusted), so you can relate to them. If all goes as planned and projected, at retirement Ernie will have roughly $948,750 of purchasing power. He’ll actually have more than twice that in nominal dollars, but they’ll only be worth $948,750 in today’s dollars. The bigger nominal number has no sensible meaning; but you can certainly relate to the smaller real number because you have a feel for how far money goes today. (Actually neither figure carries any sensible meaning; what does have meaning is the $37,950 of annual spending that it will buy you. But that’s a whole other subject.)

In the example we constructed there’s another hidden implicit assumption. A few posts ago, we turned Ernie’s savings target into an annual savings goal of $11,426 (some of which is provided by his employer). Wait, you say, if he only saves $11,426 each year he won’t have enough at retirement after taking inflation into account. Good catch! But there’s this other hidden implicit assumption: That Ernie’s salary will increase with inflation. If it does, then when Ernie goes through this exercise next year, if all projections were to come to pass, his annual savings goal would increase by inflation, but it would remain the same percentage of his salary (11.426%). Ernie will have achieved his primary objective of having Future Ernie spending just as lavishly as Present Ernie, no more, no less. (This is the exact point made by an astute commenter to Wednesday’s post, some person named Anonymous.)

Is it reasonable to assume that your salary will increase with inflation? Ernie thinks it’s reasonable for him. What about you?