My wife’s grandfather likes to regularly comment on how fast the price of everything seems to be increasing lately. He’s loudly adamant that the rate of inflation is actually speeding up and that prices are doubling faster and faster and faster. He strongly encourages me to estimate high for inflation when I do my financial figuring.
Whenever someone declares something that adamantly, especially someone that I respect as much as her grandfather (anyone who is old friends with a Nobel Prize winner and can have eloquent discussions on almost any topic will earn my respect quickly), I’ll usually check out what they’re saying, even if my initial reaction is to write it off as ramblings. I took a deep look at the detailed inflation data over the history of the United States, using the consumer price index as a baseline. I calculated the average annual rate of inflation over ten different time bands to see what the change was like. Feel free to play around with that tool using different starting and ending years – the numbers are quite interesting.
What I found was that the really bad period of inflation in the United States was in the 1970s, a simple fact that many economists could tell you. If you look at the ten years from 1973 to 1982, the average annual rate of inflation was an astounding 8.99%. This means that prices from January 1, 1973 to January 1, 1983 went up 136%; in other words, a car that cost $5,000 on January 1, 1973 would have cost $11,826 just a decade later. That’s an incredible amount, an inflation rate that seems alien to people my age.
On the other hand, over the most recent ten years in the calculator (1996-2005), the average annual rate of inflation is only 2.46%. To use that same car analogy, if you bought a car on January 1, 1996 for $5,000, that same car on January 1, 2006 would cost only $6,375.
My wife’s grandfather’s thesis is pretty clearly incorrect – inflation is a lot better today than it was a few decades ago. However, even asking this question brings up an interesting one: how much inflation should one plan for?
If you plan for low inflation rates, then every year with a high inflation rate hurts you. For example, let’s say you planned to have an annual income equivalent to $50,000 a year now when you retire in 30 years and you assume a 2% inflation rate. This means you’re expecting to have an income then of $90,568 a year. A thumbnail calculation says that you can reach that level of steady income by having 25 times that in your portfolio when you retire, so you plan for a $2.2 million portfolio when you retire. What happens, though, if inflation averages 4%? Your planned $90,568 a year retirement will still happen, but that money will only have the buying power of a $27,900 salary today! Moving from an income of $50,000 a year to an income of $27,900 a year is a major letdown.
If you plan for high inflation rates, your annual amount for retirement is much higher now, but every year of low inflation helps you. Let’s say, again, that you plan to have an annual income equivalent to $50,000 a year when you retire in 30 years, but this time you assume a 6% annual inflation rate. This means that you’re planning for an annual income of $287,174.60 when you retire. A thumbnail calculation says that you’ll need a $7.2 million portfolio to retire with an annual income like that – ouch! However, let’s say that inflation averages 4% here? Your planned $287,174.60 will still happen, but that money will have the buying power of an $88,000 annual salary today! Moving from an income of $50,000 a year to an income of $88,000 a year is wonderful!
Because of this, I strongly encourage you to estimate high when figuring for inflation because you’re always better off having more money when you retire rather than less money. This way, if my wife’s grandfather turns out to be right, you’re not caught with a poor retirement plan, but if he’s wrong, you’ll be going on European vacations when you retire.