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.
This common retirement planning mistake is best illustrated with an example. Suppose you enter the following information in a retirement calculator that ignores inflation:
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 the calculator ignores inflation, it 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.
Who among us builds a landscaping plan by saying: "I'll plant a redwood tree, which will grow to 100 feet tall. I'll also plant dozens of other species of trees and shrubs, but I'll assume they'll stay the exact same size as they are now." It's great that we allowed sufficient space for the redwood tree, but if we don't do the same for everything else we plant, we are asking for trouble down the road.
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?
The short answer is, not really. One problem is that your investments may not be directly correlated with general inflation. But the biggest pitfall of 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 health care costs, housing expense, Social Security benefits and one-off events.
These special categories represent a major portion of a retiree's economy and each has to be projected with its own appropriate growth rate. We also need to reflect when major expenses and income begin, change or end.
Back to our landscaping analogy, it won't be much of an improvement if we say: "Every tree, flower and shrub will grow by 2 feet a year." Not only do different species grow at different rates, but their growth rate changes over time. And we may decide to prune some plants after they reach a certain size to prevent them from growing any bigger.
Each financial aspects of retirement also follows its own unique growth pattern.
Health care and housing 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 geographic area.
Health care and housing expenses often change abruptly over time.
You cannot plan when you get sick or when your home needs urgent repairs. However, there are many changes in your health care and housing expenses which can be anticipated in advance. For example, your housing expense 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 the health premium tax credit doesn't pay for it). Then it can drop to 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 everyone's situation is different, health care and housing 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 (SSA) 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 the future growth in each relevant economic variable.
If your retirement calculator doesn't calculate your Social Security benefit on future dollars basis, consider overwriting it with the future dollars estimate from an SSA calculator.
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.
The Social Security Administration publishes its own long-term assumptions for these cost-of-living adjustments (2.4% in the 2021 OASDI Trustees Report). However, if your retirement calculator doesn't allow you to specify a separate inflation for your Social Security payments, it may be fine to use your general inflation assumption instead (for example, 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.
We have all planted that tree that was supposed to grow tall and strong, but instead withered and died. Or that shrub that was supposed to reach only 6 feet, but grew into a 10-foot monstrosity. But the solution to uncertainty is not to assume that nothing will ever grow. Instead, we make reasonable assumptions based on the best available data, and then make adjustments along the way when things don't go according to plan.
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 health care exchanges provide health premium information for each age and ZIP code.