The Simple Reason You Can't Know Your Retirement Number

By Michael Douglass Markets Fool.com

The idea of finding your "retirement number" -- the amount you need to save to live a comfortable retirement -- is very appealing to many Americans. And don't get me wrong: the idea behind the retirement number is good: It encourages people to plan and make a budget.

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Unfortunately, particularly for someone far away from retirement, it's impossible to know exactly what your retirement number should be.

Image source: Getty Images.

The key problem

There is one key part of your retirement number that you can't know yet: the future value of your money. Inflation is tough to predict on an annual basis, and when you get into planning a retirement 30 years down the line, it's even harder.

Consider this: Investing analysts make annual predictions about whether the stock market will rise or fall each year (and by how much) -- and their estimates are consistently, incredibly off. According to the Bespoke Investment Group, as reported by The New York Times, analysts since 2000 have predicted that the stock market would rise by 9.5% per year on average when in reality, it has only increased by 3.9%. That includes, by the way, predictions that the market would rise in 2008, at the beginning of the Great Recession.

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Economists were, incidentally, no better at predicting the financial crisis and the Great Recession. And anyone who has been watching the stock market has heard interest-rate hike after interest-rate hike predicted by tons of experts, just to see rates stay flat years longer than anyone (yours truly included) would have guessed.

To recap: The experts can't with any accuracy predict things a year from now. How can an expert (or, for that matter, you) be expected to see 30 years into the future?

It could be a portfolio killer

"OK," you may be thinking, "so we don't know whether inflation will increase by 2% a year or 3% a year over the next 30 years until I retire. Is that really such a big deal?"

So, first off, inflation isn't usually nearly as low as it has been over the past ten years. Here's a chart of annual consumer price index changes (or, inflation) as calculated by the Bureau of Labor Statistics since 1958:

Data source: BLS.gov. Chart created by author.

While I don't think anyone expects to see the 10%-plus inflation that we saw in the early '80s, the fact is that we are living in an era of almost unprecedentedly low inflation. Some reversion to the mean (perhaps 4% or even 5% annual inflation) doesn't seem unreasonable for at least a portion of the next three decades. And, of course, no one can predict the future, so it could be worse.

But let's accept the premise I shared for a minute: How much difference would a percentage point make in your retirement plans?

Quite a bit, as it turns out.

Let's say you need $1 million in today's purchasing power for a planned retirement 30 years from now. To achieve that level of purchasing power, you need to save a total of $1.8 million to account for a 2% inflation rate. At a 3% inflation rate, that number jumps to $2.4 million.

Here's what you can do

Don't stop reading just yet, because there are a couple of silver linings: First off, Social Security is indexed to a form of inflation (the CPI-W), so its purchasing power should stay relatively constant, assuming of course that benefits aren't reduced by budgetary constraints starting in 2034. The government has always stepped in to replenish the Social Security fund in the past, so I think concerns about the program reducing benefits are overblown.

Secondly, if you have 30 years until retirement, you have plenty of time to adjust your savings plans for different scenarios. If you built a retirement plan with the expectation that inflation would remain low, create another scenario in which inflation is significantly higher (perhaps 4%) and work the same math. If you're unsure where even to begin retirement planning, start here and get to work.

Retirement planning ultimately all comes down to two key things: Having a plan, and commiting to saving lots of money. If inflation looks like a daunting hill to summit, remember this: Large-cap stocks have historically returned 10% annually before accounting for inflation...and about 7% after. Time is your ally; use it to get the retirement you deserve.

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