Retirement Planning: To Inflate or Not to Inflate

            In retirement planning, the question arises as to when to adjust income and assets for inflation.  This problem appears often in questions posed by the CFP® Board on the certification examination for the CFP® designation.  Students are frequently unsure as to when a calculation of retirement income or of a retirement fund should be adjusted for inflation.  The effects of inflation can have a huge impact on these calculations, and it is important to adjust adequately for inflation to prepare clients for retirement. 

 

            In retirement planning, one of the most common examples of the need to adjust for inflation is in forecasting the income that will be needed in retirement.  If the client is many years away from retirement, the income that is adequate for the client’s lifestyle needs to be adjusted to keep pace with inflation in order for the client to maintain this lifestyle in the future.  It is important, therefore, in calculating retirement income to make the adjustment for inflation by computing the future value of the income earned today.  This calculation can be performed easily on a financial calculator by entering the client’s current income as its present value (pv), the inflation rate (i), the number of periods to retirement (n), and then you obtain the future income needed by pressing the key for future value (fv).

 

            Just as it is important to know when to adjust for inflation, it is important to know when not to adjust for inflation.    Adjusting for inflation at the wrong time can be just as detrimental to the retirement planning as failing to make the inflation adjustment.  Perhaps the most common example of when not to adjust for inflation is in computing the assets that will be available to the client at retirement.  Assets do not automatically increase due to inflation.  They can increase from investment returns and from appreciation, but these are not inflation adjustments.  One must be careful not to adjust investments and assets for inflation because they grow due to factors other than inflation.  Thus, if a planner needs to calculate the value of assets owned by the client in order to determine how much they will be worth at the time of the client’s retirement, the planner does not use the inflation rate to calculate this value.  The planner must use the rate of return that the assets can expect to achieve.    The calculation is similar to the calculation we did for inflation, but we use the investment return rate instead of the inflation rate for (i). 

 

            After the planner has calculated the amount of income needed for the first year of retirement, the planner generally needs to calculate the fund that will be required to provide this amount of income for the remainder of the expected retirement years.  The planner will need to take into account inflation over the period of retirement, and the planner must take into account the investment earnings that can be expected from the assets in this retirement fund.    In other words, in this calculation the planner needs to increase the income each year for inflation and provide the amount of income from both the existing assets and the investment returns they will earn.  Since the payments will increase for inflation, these are serial payments.  The increases in payments for inflation will in effect mean an offset to the investment returns, so the planner can compute an inflation adjusted rate of investment return. 

 

            For example, suppose a retirement planner wants to determine the fund a client needs at retirement if the client will need $60,000 of income in the first year of retirement.  The client assumes that after retirement inflation will run 3%, investments will earn 6%, and retirement will last 25 years.  In this calculation, the investment return of 6% must be adjusted for 3% inflation by using the adjustment capability on the financial calculator or by computing the inflation adjusted rate of return by the following formula: 

 

 

   (1 + Investment rate )   - 1 x 100      

     (1 + Inflation rate)  

 

In this case, the inflation adjusted rate of return will be calculated as follows:

 

(1.06)  -1  x 100 = 2.9126

(1.03)

 

Now, we use this amount for (i) in computing the amount needed for the retirement fund.  The keystrokes on a financial calculator will be in Begin Mode because the client needs the money at the beginning of the period.

 

2.9126, i

25, n

60,000, PMT

PV

 

The result will be 1,085,764.

 

            These three computations are the basic retirement planning calculations:  only two of them require inflation adjustments, and the inflation adjustment is done in different ways.  Although these computations are not difficult in themselves, they can be made to appear more complicated if they are combined.  In other words, a student may be asked a question that requires more than one of these calculations.  For example, on a test question the student might be asked to compute the retirement fund needed if the client will retire in 10 years and wants to have $50,000 in today’s income.  The client assumes that inflation will be 3%, investment returns 6%, and length of retirement 25 years.

 

            This problem requires two of the previous calculations to get the answer.  First, the planner has to calculate the future income need by making the inflation adjustment of the current income of $50,000.  This calculation is the first one demonstrated above.  Before undertaking the calculation of the retirement fund, the planner must recognize that there is a need to do the inflation adjustment of the income.  After calculating the income need for the first year, the planner will perform the calculation of the retirement fund using the inflation adjusted rate of return.   If this is a question on the CFP® Board certification exam, the signal to the student that the income must be adjusted for inflation is the phrase “In today’s dollars.”    Other phrases that might signal this need for inflation adjustment are “cost of living adjusted income” or “adjusted to future dollars.”  Any phrase that suggests the income is stated in current amounts and not in future amounts should tip the student to the need to adjust for the inflation that will affect these amounts.             

 

            In approaching the retirement planning calculations, it is helpful to break them down into these basic calculations.  The combinations only require more steps.  The calculations are still the basic ones, and are not any more difficult.  What appears complicated and difficult is really only comprised of small steps.