ALEXANDRIA, VA (Oct. 15, 1999) -- Everybody knows that inflation is the enemy of the long-term investor. Of course, it's an even worse enemy to the long-term saver, and it's not very friendly to folks who just live a long time, either. About the only people it benefits are long-term debtors with fixed-rate loans, and they have so many problems that I don't begrudge them a friend.
Since we all hope to be among the long-lived (and debt-free), let's talk about inflation today. I even have a visual aid. It's a very simple (i.e., you won't go nuts trying to work it) inflation calculator.
This nifty tool lets you see what inflation has done to dollars over the last 200 or so years or for any period in between. For example, it shows you that to get the buying power of one million 1950-strength dollars, you would need $6,689,685.24 today -- a sobering thought for those of us planning to retire early. A million dollars just isn't what it used to be.
Over a more realistic time span, let's consider a couple who started planning to retire 30 years ago. Their plan was to retire at the end of 1998. In 1969, they had a very respectable household income of $30,000. To retire with a comparable yearly income at the end of 1998, they would need a portfolio that generates approximately $137,000 a year. If you subscribe to the 5% rule, i.e., that you should take no more than 5% out of your portfolio each year, that couple would need a portfolio of $2,740,000 to retire at the same level of household income that they enjoyed in 1969. (Of course, there are myriad reasons why they might need less than that, or even more. We covered some of those issues in a Retirement Needs/Planning series that started June 28, 1999.)
Do you think our mythical couple would have figured on needing that much? I don't know. But if they had invested just $2,000 per year in the Foolish Four stocks (in an IRA), they would have made it with a couple hundred thousand to spare. Of course, they wouldn't have known that then.
That's the rub. You have to make some educated guesses and take your best shot. And that's not easy. But here's how to do the inflation part. (Math Alert: The following formula contains exponents. Brace yourselves.)
You can project today's dollars into the future using the following formula:
Today's dollars x [(1+inflation rate as a percentage) to the power of t]
where t = the number of years
How much will you need in 30 years to equal the buying power of $50,000 in today's dollars, assuming an inflation rate of 3%?
$50,000 X (1.03^30)
$50,000 X (2.4272) = $121,360
To calculate 1.03 ^30, just use the calculator that comes with Windows (Mac users, sorry, you probably have one, too, but I don't know for sure). Click on View/Scientific to get the x^y function, then enter 1.03, x^y, 30, =. You should get 2.4272624711896603386424798782582. You can round it off.
FYI, the inflation rate for the century has been 3%. For the last half of the century, however, it has been 4%, and for the last 20 years it has averaged 4.5%. The more recent higher numbers are due to the high inflation of the late '70s and early '80s.
What really counts is not past inflation but the inflation that is coming. Inflation has been running just 2% annually over the last five years. No one can predict for sure what it will be in the future, but most economists see it staying in the 2-3% range for a while -- barring things like major wars, oil shocks, or global environmental disasters. Cross your fingers.
The inflation rate for the next few decades is as important to your retirement plans as the rate of return on your portfolio. Unfortunately, it isn't something that individual investors have any control over. (Unless you are Alan Greenspan. Alan are you reading this? Good job, so far!)
The best you can do is know that it's coming and plan for it as well as you can. Hopefully, this will help.
Fool on and prosper!