How to Factor Inflation and Life Expectancy in Retirement Planning
No one truly knows what inflation will be or exactly how long they need their money to last. And, if you did, then, retirement planning would be easy. As every situation is unique, it requires using historical comparisons and rules of thumb.
Run Best and Worst Case Examples Using Assumptions About Inflation, Rates of Return, and Life Expectancy in Retirement
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 a 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/or retirement planning software. An online retirement income calculator can help you run a similar analysis.
Best Case Example
Let's assume you need $50,000 per year to spend above and beyond your guaranteed sources of income. Below are the remaining best-case assumptions:
- 2% inflation rate
- 25-year life expectancy
- 7% 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.
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% 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.
How Much Money Will You Need to Retire?
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/or take the time to read several books on retirement planning.