The difference between a reliable retirement strategy and one that could be potentially thousands of dollars off the mark is in the small details. Including a reasonable estimate for inflation in your retirement planning is one of those details that can make an enormous difference. Still, most online retirement calculators either ignore inflation or don't give it the attention it deserves.
This common issue across most retirement calculators is best illustrated with an example. Suppose you enter the following information in the typical retirement calculator:
Desired retirement income (in today's dollars): $40,000
Current age: 35
Retirement age: 65
Life expectancy: 95
Current savings: $20,000
Assumed future investment return: 5%
Since most calculators try to keep everything in current dollars, they won't project your desired retirement income of $40,000 - it will be kept constant at retirement (30 years from now) until you die (60 years from now).
At the same time, your $20,000 of current savings will be increased with your assumed investment return of 5% to your retirement date and beyond.
Clearly something is off when your savings are inflated and your expenses aren't.
If this is not accurate, why do most banks use this approach in their calculators?
The primary goal of financial institutions is to help you better understand and manage your investments. Many of these calculators won't simply increase your investments with 5%. They will help you figure out a reasonable investment return assumption based on how you are invested and may even give you a range of possible investment results. Investments are the main focus of these calculators, and that's a very valuable service in itself. These calculators are simply not designed to forecast your retirement income needs. To develop a realistic forecast of these needs, you will want to use a more sophisticated calculator.
What if I subtract inflation from my assumed investment return (for example, use 3% instead of 5%)? Then inflation is taken out from both sides of the equation. Would that work?
One potential problem with this is that your investments may not be directly correlated with inflation - that would be a question for your investment adviser. The more important flaw with this approach is the issue we discuss next.
We are not suggesting that retirement calculators need to use a different inflation rate for bread, cheese, and wine. It is perfectly fine to use a single inflation rate for all personal expenses. The issue is when this same general inflation is also applied to your healthcare costs, home-related expenses (including any mortgage payments, property taxes or rent), and any one-time events.
These special categories represent a major portion of retirees' expenses. Using the same general inflation on them creates at least two major problems:
Healthcare and real estate inflation can be dramatically different from general inflation.
While personal expenses can be expected to grow with the Consumer Price Index (where an appropriate long-term assumption can be something like 2%), fixed-rate mortgages will have 0% inflation. Your property taxes or your rent will grow with the real estate inflation in your area. Health premiums can grow by as much as 7-8% per year depending on your age and geographical area.
Healthcare and home expenses often have large declines and spikes over time.
You cannot plan when you get sick or when your home needs urgent repairs. However, there are many changes in your healthcare and home expenses which can be anticipated in advance. For example, your home expenses will drop significantly once your mortgage is paid off. Your health premium can be extremely high if you retire before 65 and buy health insurance on your own (and Obamacare doesn't pay for it). Then it can drop as low as zero when Medicare kicks in, if you don't purchase any additional coverage. It is also very likely that your out-of-pocket expenses will start increasing as you age.
Since there are so many moving parts and since everyone's situation is different, healthcare and home-related expenses simply have to be projected separately. Calculations need to reflect your individual timing and preferences and use the best available data-driven projection models.
Similar to everything else, your Social Security benefit should also be projected based on the best available data and assumptions. There are two parts to that:
Know how much your benefit will be when you retire
Your future Social Security benefit estimate needs to reflect a reasonable assumption for your future salary growth, future changes to the average wage index and, if you are a high-income person, future changes to the taxable maximum. The good news is you can get exactly this kind of benefit estimate for free from the Social Security Administration's Quick Calculator or Online Calculator. Just make sure you select future dollars (not current dollars). The future dollars estimate reflects your assumed future salary growth and the SSA's best assumptions about future growth in each relevant economic variable.
Please be aware that most retirement calculators that calculate your Social Security benefit use a current dollars approach where everything is kept constant, so you are better off using the number from the SSA's calculators.
Know how your benefit will grow after you retire
Your calculator needs to reflect a reasonable assumption about future cost-of-living adjustments to your Social Security payments. If your calculator is sophisticated enough to apply inflation to your expenses, it should apply inflation to your future Social Security payments as well.
The Social Security Administration publishes its own long-term assumptions for these cost-of-living adjustments (2.4% in their 2020 Trustee Report). However, if your retirement calculator doesn't allow you to specify a separate inflation for your Social Security payments, it is fine if it uses your general inflation assumption instead (say, 2%). You will be underestimating your future Social Security payments, meaning you will likely get a little more money each month than you planned for.
There's an abundance of data and research available to make a reasonable, inflation-adjusted projection of all major components of your financial reality. The Social Security Administration publishes an annual report with long-term assumptions regarding everything that affects your Social Security benefits. The Bureau of Labor Statistics publishes a wealth of annual and historical data. The healthcare exchanges provide health premium information for each age and ZIP code. There is no excuse for a retirement calculator not to provide a thoughtful and complete projection of all of your expenses and benefits in retirement.
If you would like to see these principles implemented in practice, you can try our free online retirement calculator, MoneyBee. In addition to projecting each major component of your financial life with its own inflation, it also provides research-based defaults for many of these assumptions.