Planning for your retirement and working out how much you’ll need to enjoy a good standard of living after your working years can be a complex task, and one factor that needs to be considered is inflation.
Inflation is the measure of a change in the cost of living and it usually rises each year, reducing the amount that you can buy with your money. It can also reduce the value of income you receive from superannuation investments which means it may make it more difficult to maintain the standard of living you’d hoped for.
According to the Australian Bureau of Statistics (ABS), Australia’s average annual inflation rate over the past 25 years has been 2.5% per year. In effect it means that the dollar today is worth around half what it was from 25 years ago.
Or in other words, and framing this in a retirement income planning scenario, it’s likely that a $5 coffee today will cost you around $10 or more in 2044.
Deciphering ‘Today’s Dollars’
When it comes to working with retirement calculators to plan how much you’ll need after you’ve finished working, it is important to factor in inflation and understand the term ‘Today’s Dollars’ and how that affects you.
But first, let’s take a quick look at how inflation is defined and calculated.
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The most well-known indicator of inflation is the Consumer Price Index (CPI), which measures the percentage change in the price of a basket of goods and services consumed by households.
This hypothetical basket includes thousands of consumable items across 87 categories and 11 groups and the CPI is calculated by the ABS every quarter.
If your retirement income stays the same while prices go up, you’ll have less purchasing power and you’ll have to make some changes to your budget.
If your income rises by the same percentage as the inflation rate, your purchasing power will stay the same, and of course if it rises by a percentage greater than the inflation rate, you’ll be able to afford more goods and services. This is the ideal scenario.
Using retirement calculators
There are many good retirement income calculators out there which give you a good idea of how much you need to save to enjoy your ideal lifestyle after you’ve finished work.
These calculators usually start with asking you how much retirement income you will need each year in ‘Today’s Dollars’.
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Other basic calculations that add to the equation include your age, your current savings, super balance and contributions, planned retirement age and anticipated yearly returns on investments among other factors.
A good retirement calculator will also, and often right at the end, require you to enter the expected inflation rate. As we mentioned earlier, in Australia the average inflation rate over the past 25 years is 2.5%.
So when the calculator asks you how much you’d like to receive in retirement in ‘Today’s Dollars’, it means that the actual amount you will receive in the future will be adjusted higher for inflation so that it has equivalent purchasing power to the stated amount currently.
For example, this basic calculator from the US shows that someone who is aged 35, wants to retire at 65 with $60,000 income will need to have saved $517,907 and therefore will need additional savings of $4,677 per year for 30 years. This is based on the assumption there is no inflation.
If you add a calculation for expected inflation of 3%, that number changes rather dramatically to $746,585 in total with additional savings of $12,733 per year required.
Understanding this part of the calculation is important because once you’ve retired and exited the workforce, your purchasing power from your retirement income will be influenced by inflation.