I argue why we should use a personal inflation rate while planning for retirement. 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 15 years is a reasonable estimate. So it keeps changing (as it should!), and we must 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 the personal inflation rate (link points to a free calculator). They were shocked that the rate was much higher than 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.).
So what is to be done? I recommend playing around with the inflation numbers (and return estimates – linked!) in our robo-advisor tool until the investment amount appears manageable. Of course, one cannot set the inflation to 2% or 3%, but one can set it as close to reality (your inflation rate) as possible.
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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 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 6% inflation and find out how long the money would last or what the withdrawal rate (current annual expense divided by total corpus in hand) is. 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 must consider buying a fixed annuity policy or RBI/Gilt bonds 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 expense inflation. Else, it will have to be lower.
How low it can go before considering an annuity is subject to debate. Our research – implemented in the freefincal robo advisor tool – shows that to successfully combat the sequence of returns risks (a string of poor equity returns, particularly at the start of retirement), one chunk of the corpus should be large enough to provide inflation-indexed income for the first 15 years of retirement. The remaining chunk should be large enough to handle the rest of retirement.
For an example of this implementation, see Retirement plan review: Am I on track to retire by 50? Also see: When should senior citizens purchase an annuity?
Thus, much 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.