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Let's say one had a goal of saving $x, in order to live off of (say) 4-5% interest on the principal.
How do you then account for inflation? Do you assume some rate and increase how much you would have to save for, or subtract this from the realized interest?
So if I wanted $1 million, at 4%, do I actually need to now get 5%?
When you're estimating how much you'll have saved at retirement, subtract the average rate of inflation from your estimate of how much your savings will grow each year. For example, if you expect your retirement account to grow at 8% a year, and you expect inflation to be 3% each year, use 5% as the estimated growth rate instead of 8%.
Once you reach retirement, add an estimate for the inflation rate to your annual withdrawal rate. For example, say you've reached retirement with $1 million. If you expect to withdraw 4% each year, but you expect inflation to average 1% each year after you retire, plan on withdrawing 5% a year instead of 4%.
This lets you adjust for the decrease in the purchasing power of your money. For example, you may spend $40K/year to maintain your current lifestyle. However, depending on your age, $40K a year might not be enough to maintain that lifestyle at retirement because of the effects of inflation. At retirement, you might need $50K instead.
This answer to the question "Saving for retirement: How much is enough?" is also worth a read too.
I use 2 distinct calculations:
Arrive at the retirement Goal. The way I arrive at this is arrive at the expense at current costs for present lifestlye. I then multiple this by Inflation factor that would change every year. The retirement goal would be an amount that would give me this amount at a conservative rate of interest. I also put in furture big ticket expenses [Kids education, etc]
Savings Stream. Calculate the sum of savings using an assumed rate of interest. Every year adjust this for the actual growth in savings.
The difference in these would show the short fall or surplus.
Keep revisiting this every year.
The reason for increasing the retirement goal by inflation help put an absolute number rather than adjusting the actual savings by a factor.
I wrote an article Retirement Savings Ratio, which links to a spreadsheet you can download.
The approach I took was to look at the goal of having X times your final income saved for retirement. It turns our that if you start saving at age 20, and retire at 62, by saving 15% of your gross income, you'll have 20X your final earnings in your retirement account. The sheet allows you to adjust the inflation/income increase each year, percent saved, and the annual return. To keep it simple, I don't have different numbers for wage increase vs inflation.
The criticism of the method - (a) salary should increase faster than inflation. (b) returns aren't level each year. (of course not, one can make such exercises as complex as they wish. I chose to use an 8% return, thinking that was a conservative number.) (c) a final year drop in income distorts the ratio saved. (Well, yes. Savings needed is really a function of spending, not income. So the required ratio isn't the same for everyone.) (d) I ignored Social Security. (Indeed, but the sheet doesn't change, just the ratio that will make you happy. You earned $100K, and spent $80K/yr? $20K in SS benefits? You need $60k/yr to replace the needed income, $1.5M will provide that. A 15X ratio)
One can tinker with the sheet easy enough. The main point it to have an ongoing goal of X times income to see that you're on track. Last, the 15% is total savings, your deposit plus any company match or pension deposit.
Consider how/when your income is taxed when adjusting for inflation. e.g.
Incorrect: 7% gross investment return - 2% inflation = 5% gross real return, - 20% avg tax = 4% net real return
Correct: 7% gross investment return - 20% avg tax = 5.6% net investment return, - 2% inflation = 3.6% net real return
That's a 10% difference in net real return!
Note the above assumes that ALL gains are realized and taxed at the END of each year.
5 - 1 = 4%. To calculate pension fund value you may find this useful. – Chris Degnen Jan 3 '14 at 9:24