One reason people tend to underestimate their retirement saving needs is that they fail to properly account for the impact of inflation. Even in the current era of relatively mild inflation, the steady accumulation of price increases over a period of years can still have a profound effect on how much money you will need in retirement.
Time is what gives inflation its power. In setting retirement targets, you not only have to account for the compounding effect of price increases between now and when you retire, but also for the continued impact of inflation over the years you spend in retirement. For a 40-year-old, this means having to think of both a 25-year (from the present to retirement age) and a 50-year (remaining lifespan) time horizon.
Here is how various inflation environments could affect your retirement plans.
Over the past 50 years, the Consumer Price Index has increased at an average annual rate of 4.15 percent. That may sound reasonably innocuous, but at this rate you could expect prices to increase by 176 percent over the next 25 years. That means for every $100,000 you would need for retirement today, you would need $276,000 in 25 years to have the same purchasing power.
That same 4.15 percent inflation rate would amount to 663 percent over the next 50 years, meaning that it would take $763,000 at that point to have the same purchasing power that $100,000 has today.
Even normal inflation can add up to some daunting price increases over time, but the numbers can be staggering during periods of high inflation. During the 1970s, prices rose by an average of 7.9 percent a year. If that rate of inflation continued for 25 years, it would represent a total price increase of 494 percent, requiring you to have $594,000 for every $100,000 you would need at today's prices.
Over 50 years, that 7.9 percent rate of inflation would represent a total price increase of 3,433 percent, in which case you would need more than $3.5 million just to have the same purchasing power that $100,000 has today.
It is rare, but prices do sometimes go down. This is what is known as deflation, and while you might like the idea of falling prices as a consumer, deflation tends to be a symptom of a chronically weak economy. In that environment, you are likely to have trouble earning the investment growth you need to reach your retirement targets.
Over the past five calendar years, inflation has been unusually low at an average annual rate of just 2.10 percent. Continued inflation at that rate would amount to a total increase of just 68 percent over 25 years, and 183 percent over 50 years. Still, even with low inflation, you would need $283,000 in 50 years to replicate the purchasing power of $100,000 today.
Despite low inflation, keeping pace is especially challenging these days because of low bank rates. Bank rates normally adjust to a level just above inflation, but they have lagged behind price increases in recent years. This has driven investors more heavily into the stock market, but the risk there is that a bear market could put you behind inflation for years to come.