Retirement: The inflation threat

NEW YORK (Money) -- Question: I want to estimate the effect inflation will have on my retirement income. For example, if I have a retirement income of $60,000 a year and inflation runs 3 percent a year, how much will inflation affect my buying power in say, 10 or 20 years? How do I do this? Is there some sort of formula I can use? - Carl Willis, Atlanta, Georgia

Answer: Gauging the effect that rising prices will have over the course of many years on purchasing power is a hugely important consideration in retirement planning - and, unfortunately, one that many people aren't factoring into their preparations.

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I can't tell you how many emails I get from retirees telling me they need annual income of $60,000 or whatever amount from their savings and asking me to recommend an investment that will generate that amount.

What they don't realize is that 10 or 20 years from now $60,000 - or however much they start with - isn't going to buy as much in food or clothing or medical services or entertainment as it will today.

Unless inflation disappears - which I don't think anyone believes will happen - you're going to need a lot more than $60,000 in the future to get what $60,000 will buy in goods and services today.

I mean, just take the case of a car. Thirty years ago, a new Chevy Impala cost less than $5,000. You'd have to shell out $20,000 more for a 2007 version. So how do you get a sense of how much inflation will erode your buying power over the years?

Well, I think the better way to think of this issue is to turn it around. In other words, instead of thinking of how much less your $60,000 a year will buy, think of how much more money you will need in the future to buy the equivalent of $60,000 in goods and services today.

After all, when you get right down to it, that's the issue you face. How many dollars will you have to pull from your retirement accounts in the future to maintain your standard of living?

And that leads to a second question you and most retirees must also answer: Do you have enough stashed away to handle the rising level of withdrawals from savings you'll need to maintain your purchasing power throughout retirement?

Answering the first question is pretty simple. Let's say you're spending $60,000 this year and inflation runs 3% a year. Well, that means that to maintain the same buying power, you would need $61,800 next year ($60,000 x (1 + the inflation rate) or, $60,000 x 1.03). And the year after that you would need $63,654 ($60,000 x 1.03 x 1.03, or $60,000 x 1.03²). And in 20 years, you would need $108,367 ($60,000 x 1.30²⁰). (see editor's note at bottom)

So you can estimate how much you'll need at any point in the future for any forecasted inflation rate by going through this process using a pencil and paper, a calculator or the Future Value function of an Excel spreadsheet. Or, for that matter, you could go to a simple compound interest calculator like this one on our site.

Although it's designed to show how much your savings will grow, you can "re-purpose" it to illustrate how much future income you'll need. Just insert your annual income where it asks for Initial Deposit, use your expected inflation rate where it asks for the Interest Rate, put zero for Additional Deposits and where the calculator asks how long you'll save, just put in the number of years you want to look ahead (and be sure to choose years in the pull-down menu since we're looking at annual inflation).

The answer you'll get will be the amount of money you'll need in the future to keep pace with inflation. But while doing this will give you a sense of how much inflation will cut into future buying power (if you'll have $60,000 in 10 years but with inflation running 3 percent a year will need $80,635 to buy what 60 grand buys today, you'll be 26 percent short of what you need), it won't help you with the second question I mentioned above - namely, do you have enough tucked away in savings so that you can withdraw more and more each year?

The reason is that this issue is more complicated, involving not just how much inflation will increase your spending needs, but the odds that you'll be able to meet those spending needs given the outlook not just for inflation, but also the fluctuating returns you're likely to earn on your portfolio.

There are ways to get at it, though. If you just want a sense of what the odds are that your investments will be able to generate a given level of withdrawals during retirement, you can go to T. Rowe Price's Retirement Income Calculator.

But if you really want to get a sense of how well prepared you are to meet your retirement spending needs, then you want to estimate both what your future inflation-adjusted spending needs will be and how likely you'll be able to meet those needs from all your retirement income sources, from Social Security to any pensions to your retirement investments. The Retirement Income Planner tool on Fidelity's site can do this sort of analysis. (You can use the tool at no charge even if you're not a Fido customer, although you do have to register with the site.)

On the spending side, there's an interactive budgeting worksheet that lets you break down your anticipated retirement spending into 49 different categories. You can then apply one inflation rate to all the categories or, if you wish, assign different rates to some. You can also make adjustments if a particular expense, say, a mortgage or car loan, will be paid off after a certain number of years.

The calculator will then perform computerized simulations to calculate the odds that your projected income from Social Security, pensions and investments will be enough to cover your projected inflation-adjusted expenses for the length of time you're likely to spend in retirement. If the odds are too low for your liking, you can re-run the analysis with some adjustments - paring back your expenses, investing differently or perhaps delaying retirement or working part-time in retirement.

If you're not comfortable doing this sort of number-crunching on your own, you could always consult a financial adviser. Of course, if you've got enough money, and inflation remains tame, and the financial markets are generous - in short, if all the stars are aligned in your favor -you could get through retirement just fine without going through this sort of exercise.

But if you decide to wing it only to discover after 15 to 20 years in retirement that your income can't keep up with rising prices, well, let's just say you'll have a chance to learn first-hand about just how much inflation can erode your purchasing power.

--Editor's note: Due to a formatting error, the equation above was incorrect in a previous version of the story. It has been corrected.