The Effect of Inflation on Retirement Planning

How much money do I need to retire? Or stated another way: How much money do I need to achieve the freedom to BE ABLE to retire…in other words, to make work optional?

Is that a question you think about? Does it keep you up at night? Well, if you don’t know the answer, it SHOULD keep you up at night. Believe it or not, you can calculate just how much it will take for you to retire at a given age with a reasonable expectation that you won’t run out of money before you die. And it’s really not that complicated. Maintaining the discipline to stick to a plan to get you there is the hard part. Consider this quote from Morgan Housel’s bestselling book, “The Psychology of Money:”

“…building wealth has little to do with your income or investment returns, and lots to do with your savings rate.”

Let’s analyze how we might answer the question “how much do I need to retire” and examine the effects of inflation on our calculations.

Start with how much you need to spend each year

A good starting point would be to estimate how much money you need to spend each year in retirement. Estimating your spending needs in retirement is much easier as you approach retirement, but in order to achieve financial freedom, you’ll need to start saving many years earlier. Estimating the need is more difficult the further away from retirement you are. You might start by looking at your budget to determine which expenses will carry on through retirement and which ones will end before you get there. Examples of expenses that could go away are college savings/expenses for your children, childcare, commuting costs, and maybe your mortgage. Also, you won’t be saving for retirement any longer, so that’s a big expense off your plate. But for simplicity, you could just use current household income (minus what you’re saving for retirement). However, be aware that if you use current household income to estimate future retirement spending, large increases in income will increase what is needed in retirement, in which case you may need to increase your savings rate to match along the way.

Factor in some healthcare costs

Healthcare for retirees will likely be one of the largest single categories of spending for most. You’ll need to use some sort of estimate for out-of-pocket medical expenses in retirement. Two recent studies (by Fidelity and RBC) estimate out-of-pocket medical expenses for a healthy 65-year-old couple to be around $12k per year. You’ll also need to make an assumption on healthcare cost inflation.

Include taxes

In addition to general living expenses and healthcare, you’ll need to include an estimate for income taxes. Predicting future income tax rates is an impossible task, so we’ll just use current rates for simplicity. If you feel rates will be higher in the future, you may want to adjust accordingly to be more conservative.

Withdrawal rate assumptions

We’ll need to make some general assumptions around safe withdrawal rates for different lengths of retirement, and we will use updated Trinity Study results from the Poor Swiss blog as our guide. This is not an endorsement of those results or a guarantee of success but simply an estimate for illustrative purposes. Use a lower rate if you want to be more conservative.