One of the most controversial aspects is the concept and the far reaching effects that inflation has on us all. For those who disregard inflation there will either be a hard landing in the future or they have sufficient financial backing to remain almost visibly unaffected in terms of their overall net worth. For the vast majority of us it is not just the fact that inflation exists but more how it really has a cumulative effect on us all as time goes by. This is viewed by many as something they do believe but cannot see how it will damage them until it actually happens and it is too late.
Let's say that your cost of living today totals $50,000 per year and inflation is 4%. The total cost of living in 20 years' time will be $111,129 per annum. Yes, we hear you say, that is most interesting and something we will need to cope with when we get there. If you try to imagine what $50,000 means to you today and then also what $111,129 means to you in reality today you will understand this intrinsic difference. However, if you need $50,000 per year to live today that would total $250,000 over five years. If it were $111,129 today that would be $555,645 over five years. So, how long would it take to accumulate $250,000? Quite some time. Now, how long would it take to accumulate $555,645? That is a huge ask is it not? Now just realise that is only living costs for a five year period and things will continue increasing in cost beyond that meaning you will need even more accumulated capital. Perhaps there are some readers who now see the significance.
The point here is to realise that inflation has a massive effect on everyone and the sooner you begin to accumulate reserves toward financial independence the better.
In a similar light compounding growth on accumulated capital savings has a positive effect in the opposite direction making your assets grow even faster than you had envisaged. To demonstrate this a little more succinctly let¹s say you have $50,000 which you invested and achieved a return of 7% per annum. In this example you could draw the accumulated interest and would enjoy $3,500pa to spend. Assuming no changes you would receive the same figure each year so over a ten year period you would have spent $35,000 and still have your original $50,000 capital. However, if you did not draw any income but instead let the growth compound you would have $100,483 which is quite a lot more than $85,000.
So, by combining the growth you receive and applying the inflation rate you may need to bear we can calculate how long your asset pool will last. Using the figures in our illustration so far let¹s assume that you are 40 years old and decide to save $1,500 per month toward retirement at a planned age of 60. You will increase this each year in line with rising salaries at say 10%. The results of these savings over a 20 year period, at a growth rate of 7%pa, will be:
So when you reach age 60 you have a total investment pension pot of $1,834,718 and so congratulations are due as this is looks like a really significant figure. Do you feel that this will last a lifetime of paying pensions to you and also maybe even have a residual balance as a legacy for your intended heirs? If you do it will be worth your looking at the next table which demonstrates how inflation crushes the plan. Taking an initial value of $1,834,718 and making this continually grow at 7%pa we now start to draw a pension, based on today's figure of $50,000 but inflated at 4%pa to the retirement date in twenty years' time. If you recall this requirement is then $111,129 in the first year. Inflation does not retire when you do so we must assume that the 4%pa inflation continues thereafter. Our next table shows how this works:
You can see that you have actually exhausted your investment pot completely by age 83. So those 20 years of savings have been wiped out completely by an inflating requirement for living expenses as you go into retirement. That includes growth at 7% and inflation at much lower level of 4%pa. Some shall say "I shall never retire" whilst others will retort "I shall die before I reach age 83". To those people we say take your head out of the sand and face reality.
Inflation may not run at 4% consistently. This tends to be relatively real although expats generally tend to suffer from higher rates than this. Investment returns of 7% are not easy to generate although it is possible. So, these examples are based far more on optimistic reality than pie in the sky guesstimates.