If you are following the traditional Financial Independence Retire Early path of saving a lump sum amounting to 25x your yearly expenses which you will begin to access when you retire, this post isn’t for you. The 4% rule has you covered, as it takes inflation into account.
But if you are a late starter, you might have superannuation or some other form of pension pot that you can’t yet access at the time you’d like to begin your retirement. This is where inflation can have an impact.
As we are following a SlowFIRE path (high expenses, relatively low savings rate for FIRE), superannuation is essential to our FIRE plans. As of 2021, we are legally able to access our superannuation when we turn 60. Unless legislation changes, that is 12 years away, in 2033.
FIRE in Two Parts
For our original FIRE goal of retiring at 60 on $80,000 a year, we can treat our savings both inside and outside of Super as a single pot. Because we won’t start to draw down until we have access to $2,000,000, inflation isn’t a concern when following the 4% rule.
But our stretch FIRE goal is to retire at 55. To do this, we will need enough in our investments outside of Super to fund five years, from 55 to 60, when we can access our Super. It’s this period of savings where inflation has an effect.
A Note on Australian Inflation Rates
The general inflation rate bandied about in the FIRE space is 3%. I’m not quite sure where that comes from, to be honest; perhaps it is US-centric. However we live in Australia, and Australia is expensive. Looking further into it, a site named Inflation Tool states that between 1949 and 2021, inflation in Australia averaged 4.88%. That’s a significant increase on the generally stated 3% rate. Backing that up is data from the World Bank which calculates an average yearly inflation of 4.69% for Australia since 1960.
Past performance is no indicator of future performance, but any modelling/prediction needs some sort of number. As I like to take a conservative view, I’ll use 4.88% for my calculations.
Accounting for Inflation
Post(?)-COVID there’s suddenly been a lot of talk about inflation rising.
When we say we want to live on $80,000 a year, we are saying we like the lifestyle that $80,000 a year can buy us today, in 2021. We want to continue living this lifestyle. But what if inflation rises to an average of 10%? That means we would need $88,000 a year to keep us.
As stated earlier, if we were working directly with the 4% rule, inflation is included. We will have saved our entire pot of 25x our annual expenses. The idea is that in the first year, we would draw down $80,000. In the second year, we would draw down $80,000 plus inflation. If that were indeed 4.88%, it would be $83,904. In the third year, we would draw down $83,904 plus 4.88% or $87,999. Of course, there is flexibility here. Inflation could vary wildly. We also might take a flexible view where some years are better and we draw down more. Others may not be so good, so we draw down less. Overall though, this approach has an excellent chance of success under the conditions of the 4% rule.
(If you’d like to read more, Jenni and Chris at TicTocLife have gone into detail – and they’ve already FIREd so they are living the reality of draw down and inflation.)
For our Stretch Goal, we need to fund $80,000 a year for five years, to cover from age 55 to 60. At first glance, the maths turns that to savings of $400,000. However assuming an inflation rate of 4.88%, if that was all we saved by the time we turned 55, it would actually be the 2021 equivalent of $286,000 or $57,000 a year for five years – way too little.
When is $400,000 Not $400,000?
When it’s in the future!
If you like to jump straight to results, you can use a Future Inflation Calculator. Below, I’ve calculated what $80,000 will be worth in each of the five future years we’d like to be retired before accessing Super. I then add up the total to find that we’ll actually need to have saved $615,573 to have five years of future buying power at the equivalent of 2021’s $80,000 a year.
Using this approach assumes we will spend the money each year as we go.
You’ll see that if I put in $400,000 in today’s dollars, then the calculation becomes even higher, at $675,584. But that is making the assumption we won’t begin spending until the end of the five year period, which isn’t true. However, if you’d like to be even more conservative, this is another option or savings goal to aim for.
Using Excel to Calculate Future Inflation
For the Excel enthusiasts, this can also be done using a calculation:
Required yearly spending x (1+inflation as a decimal)^number of years.
In our case, this means:
$80,000 x (1+0.0488)^7 (7 more years until 2028). This returns $111,670.571, as per the calculator above. Again, I sum the five years we will be retired before accessing our superannuation, which shows we will need to have $615,573 saved to live on the equivalent of $80,000 a year in 2021 dollars.
I’ve only started taking inflation into consideration in the last year or so. I don’t know how or why, but when we started with FIRE it wasn’t something I was aware of. And as I said earlier, it is only applicable to people who need to fund a period before accessing a lump sum, such as a government-run retirement scheme.
I’m glad I’ve realised now while we still have at least 7 years to continue saving. $615K is a lot more to save than $400K. And it might not be this bad. Our spending of $80,000 is averaged out over the last five years. That means that we haven’t increased our spending even in line with admittedly low inflation rates over that period. Perhaps in seven years time we will have continued to reduce our lifestyle and still be spending $80,000. But I’d rather over-prepare than under-prepare.
Have you considered inflation in your FIRE plans? Or do I have this entirely wrong? Happy to hear your comments below.