Everybody talks about inflation.
They could at least give me a raise to keep up with inflation.
How many of you have no idea what they are talking about and just nod your heads knowingly?
Here’s the Wikipedia definition:
In economics, inflation is a sustained increase in price level of goods and services in an economy over a period of time.
Sometimes definitions can make things more complicated.
I like examples. They help me understand things.
So here’s an example to try to explain inflation:
In 30 years I will have saved $1,000,000 in cash.
In 30 years, I figure $40,000/year will be a good enough net income.
(Forget about taxes for now and assume that this $1,000,000 has already been taxed.)
Situation 1 – inflation is zero
If inflation is zero, that means everything will cost the same in 30 years, so my $40,000 net income now will be able to buy the same amount of things in 30 years.
In a zero inflation world I just divide my $1,000,000 by $40,000 and I can live for 25 years on that money.
Zero inflation is like a unicorn: fun to draw, but it doesn’t exist.
Situation 2 – inflation is 1% per year
If inflation is 1%, that means every year things cost 1% more than they did the previous year.
So if a laptop is $1,000 today, in 30 years that laptop will cost $1,000*(1.01)^30=$1,347.
Or if I want to buy a $40,000 car it will cost $53,914.
So now instead of $40,000 to live the good life, I need $53,914!
But I still only have my $1,000,000.
I can divide my $1,000,000 by $53,914 and live the good life for 18.5 years, right?
That $53,914 keeps going up 1% every year so it’s more like 17 years.
You get the picture: You can’t just plan on making straight withdrawals from your $1M in cash and have it last 25 years.
Because of inflation.
SO WHAT SHOULD I DO?
First of all, your $1,000,000 should never be entirely in cash.
When you retire, you want to change your mix of investments so that it’s more conservative.
Conservative doesn’t mean all cash but it doesn’t mean high returns either.
At the very minimum you want your overall return to be higher than the inflation rate. If inflation is an average of 3% over the 25 years you are retired then it shouldn’t be hard to beat it by investing in something secure enough but has at least a 4% return.
The key to a successful retirement plan is to plan on accumulating a lot of wealth through savings and aggressive returns while you are working(and can tolerate risk).
RETIREMENT OR FINANCIAL INDEPENDENCE
Then if you have enough money when you stop working, you shift everything into as little risk as possible while still keeping up with inflation(or whatever level of risk you are comfortable taking).
In that case, we take the magic number you think you need at retirement, your $1M, and we figure out what it really needs to be based on the highest inflation amount you can think of. Then you can take your $40,000 over 25 years because you already planned for that.
Inflation, along with returns on investments, are unpredictable numbers, but when you have a lot of time to plan, you can do so based on your worst-case scenarios and know you’re still going to be OK.
The longer you wait to start planning, the harder it will be to feel comfortable about the future while still leaving lots of room for you to spend today and do the things you want.
I want two awesome life situations for you:
- an awesome working life situation where you don’t have to sacrifice luxuries
- an awesome retirement where you don’t have to work because your younger self helped you out
This is possible with a solid plan and wise investment.