What rate of inflation should I use while planning for retirement?

A reader asks, “Can you please write an article on how to decide the inflation rate while planning for retirement?”. This question has troubled me long and hard over the years, and I think I have finally arrived at an answer: “Use the rate that will work for you”!

This response may seem arbitrary to readers, so let me explain. My family’s inflation rate was about 8% some years back – Inflation in India: Some Real Numbers. So that was the rate I started with when planning for retirement. Eight per cent before and after retirement.

Then as our economy grew, interest rates started falling, and I relented a bit and assumed 7% after retirement since it is still years away. Today I think 6% inflation after 15Y is a reasonable estimate. So it keeps changing (as it should!), and we need to re-evaluate the plan each year.

Inflation before retirement

When I asked users of my retirement tools to use 8% before retirement and at least 7% after (some years back), many complained that the numbers were too high, and they spent many sleepless nights after using the calculator.

This is to be expected. My response was (is) to check your personal rate of inflation (link points to a free calculator). They were shocked that the rate was much higher, 8% (before retirement). This is because much of the inflationary increase before retirement comes from lifestyle changes (typically enhancements but can be due to illness etc. as well).

So what is to be done? I recommend playing around with the inflation numbers (and return estimates – they are linked!) in our robo advisory tool until the investment amount appears manageable. Of course, one cannot set the inflation to 2% or 3% but as close to reality as possible.

That way, one will not get frozen looking at the huge corpus required and can get started. As salaries increase, inflation can be adjusted (increased!) gradually down the line.

Inflation after retirement

What retirement is far away: Inflation after retirement is tricky, and many people incorrectly assume lifestyle creep and expenses would be lower. This is a dangerous assumption, and we recommend that inflation after retirement be set equal to inflation before retirement. This is especially necessary if the current inflation used is lower than the actual! Again one can review the inflation with time, especially close to retirement and make changes.

When retirement is imminent:  This situation is unique, particularly if the person had not planned for retirement properly. Sadly a good chunk of the current retirees would fall under this category.

Here we start with, say, 6% inflation and find out how long the money would last or what is the withdrawal rate (current annual expense divided by total corpus in hand). Lower inflation should be used if the money is likely to run out before the person’s expected lifetime.

Sometimes the inflation may need to be set at 2% or 3% or lower. Then one will have to consider buying a fixed annuity policy with a small stash of cash safely invested for emergencies.

Thus inflation after retirement refers to the rate of increase in retirement income. If the corpus is large enough, this increase in income will occur at a rate close to inflation. Else it will have to be lower.

How low it can go before considering an annuity is subject to debate. This is our line of thinking implemented in the robo-advisory tool: When should senior citizens purchase an annuity?

Thus quite a bit of thinking goes into the seemingly innocuous inflation estimate. It has to be adjusted continuously to suit our circumstances. First, to get started and then edge closer to reality. After retirement, it should be adjusted based on the strength of the retirement corpus. For young earners, the goal should be to attain a large enough corpus so that the increase in retirement income reflects their actual inflation.