Estimating nest egg and inflation

Question

First a couple paragraphs for me to lay out my understanding and then my actual question.

It is often reported that one can estimate how much they need for retirement by taking their current expenses and multiplying by 25. This comes from the idea of a 4% safe withdrawal rate which is related to a historical real rate of return on investments of 4% which arises from a 7% return less 3% for investment.

My understanding is that you start with a nest egg of a certain amount. You start off withdrawing 4% of that nest egg. Each year it appreciates by 7% and you withdraw your original 4% (of the principal) plus an additional 3% (of the total withdraw amount) each year to compensate for inflation. Long term, the net result is that this can reach a sort of steady state where the nest egg is essentially never depleted meaning there is enough there for retirement.

Question:

All of the above makes good sense to me. My question is about the validity of using my current expenses to predict even my initial expenses during retirement in light of inflation between now and the start of retirement.

Suppose my current expenses are $40,000. The 4% rule would indicate a required nest egg of $1,000,000. However, suppose it would take 20 years to save that up. Well assuming 3% inflation per year that $40,000 of spending is now $72k of spending which would require a nest egg of $1.8 million by the 4% rule.

The question is do I need to adjust my current spending amount for inflation at the beginning of retirement to accurately determine how much I need for retirement?

Note:

I'm coming from a math background so I'm very comfortable with any math/formulas and I prefer to think about things in those terms. Also, I really there are many simplifications in the model I'm presenting (largely I'm assuming no variability of any of the parameters with time) but I'm just trying to get a sense for how the numbers work in the simplest model and then I can think about how variability would affect things in real life afterwards.

This may be a duplicate of I'm trying to figure out a formula for when I'll be able to retire at any given month but my question here is a little more specific and direct.

Answer 1

Spreadsheets are really handy for this!!

I calculated my hypothetical initial retirement budget based on my current budget adjusted for:

1. what my father currently pays for Medicare Advantage (we're in the US),
2. what expenses I think might disappear,
3. what new expenses I think might appear,
4. how taxes are calculated,
5. years until retirement, and
6. estimated inflation rate.

Using the standard formula (1+r)^p, I calculated the Future Value (FV) of my budget.

Multiplied it by 12 to get the amount I'll spend in a year.

Then I calculated the FV of my current IRA, 401k and taxable investments, using a conservative rate value and the FV -- using Excel's =FV() formula -- of the 401k contributions I expect to make until retirement.

Subtract expected monthly Social Security payments from my budget to compute how much I need to withdraw from "savings" every month in my first year of retirement.

From there, I calculated how much I'll need to withdraw each year (adjusted for inflation), and how much my remaining funds will grow.

Forecasted that until age 80, based on retirement ages of 65, 66 and 67.

To reiterate: spreadsheets are really handy for this kind of work.

Answer 2

You are correct. Better explanations of the 4% rule don't say "current expenses," rather they say expenses needed in retirement, expenses right before retirement, or some other wording to help address the issue you just highlighted.

Simply applying the inflation rate for the number of years until retirement is probably a pretty good approach to keeping with a simple method for determining your number. Keep in mind that the 4% rule is just a guideline based on historic returns, there's no certainty that it won't fall apart in our lifetimes. At some point doing the more detailed retirement plan is worthwhile.

Answer 3

Adding my own answer as I've thought about it more and adding a piece that probably should have been included in the question.

First off, I think it is correct (in agreement with the other nice answers) that the actual dollar amount in the nest egg must be related to your actual expenses in the year of retirement. So you must use inflation adjusted spending to calculated the dollar amount for the nest egg.

However, this question came up for me when I was trying to calculate time for retirement. When considering time until retirement you also have to remember that your income increases with inflation as well as expenses. This means that even though the inflation adjusted target nest egg is increasing each year income is inflation adjusted by the same amount which means the total time to retirement will not change as a result of inflation.

With a bit more math and approximations you can show instead of keeping track of inflation you can convert everything to "present-day dollars" if you make sure to use the "real rate of return" on investments instead of the nominal rate of return. As an approximation the real rate of return is the nominal rate of return minus inflation. This means we can do the calculation assuming inflation is zero and the investment rate of return is 3% = 7% - 4%.

If I have time at some point maybe I'll add some of the formulas that helped lead me to all of this.

The goalpost is moving but you get faster as time goes on.