Editor’s note: Today’s Daily is a response to some important subscriber feedback concerning the Palm Beach Research Group’s 2015 Asset Allocation Guide. The subscriber asked how to take into account the effects of inflation on retirement planning. PBRG’s Editor-in-Chief Jeff Remsburg addresses this in the piece below…

Our January asset allocation issue has received lots of positive feedback. We’re pleased so many of you have found it helpful.

But one subscriber was concerned we hadn’t spoken enough on inflation.

He’s right to be wary. Inflation can have a huge effect on long-term savings.

Mark’s original “Magic Number” essay (which we referenced heavily in the asset allocation issue) did add a step for inflation that our issue left out. We suggested handling it a bit differently. But to clear up any confusion, we wanted to address both ways.

I’ll start by briefly recapping how Mark originally addressed inflation. (I include his text at the end of this essay.)

To get your “Magic Number”—the amount of money you need to retire—you make several calculations. These calculations require an interest rate.

Mark suggests that if you want to factor inflation into your calculations, you would simply use a smaller interest rate. In essence, you are subtracting an assumed inflation rate from your interest rate. When you do this, it results in a larger Magic Number.

Mark is absolutely right. This method works.

But choosing the right inflation rate is complicated. And if the rate you choose is way off, it can badly skew your Magic Number calculations. This is why we went a slightly different way in our issue.

Let’s assume you want to use an inflation rate in your calculations…

Should you use the current, government-stated inflation rate? (Around 0.8%.) A long-term average rate? (About 3.3%.) What about a 2015 projection? (I just saw 0.6%.)

These differences would produce wildly varying Magic Numbers.

It gets trickier…

How accurate are those inflation rates, anyway? Over the past 30 years, the government has changed the way it calculates inflation more than 20 times.

Here’s something else to consider…

What if you’re, say, 25 years from retirement? How do you factor in the Fed’s trillions in money printing over the last several years? This will certainly be an inflationary pressure. But we don’t know the extent… we’ve never experienced anything like quantitative easing before.

Given all this, here’s what we wrote in our issue…

  What if you’re 20 years from retirement? How will inflation affect your anticipated monthly cash flow in 20 years? Isn’t it fair to assume you’ll need more income then just to maintain “today’s” purchasing power? For all these reasons and more, it’s critical that you run these calculations every year.

When you run your Magic Number calculations at least once per year, it addresses inflation in a “real time” way.

You would look at your numbers—which reflect current inflation—and adjust your asset allocation strategy accordingly.

The alternative—providing you one “true” inflation rate to use in your calculations—runs the risk of being misleading.

For instance, let’s say we made a prediction: “Inflation will be 1% for the next two years.” And let’s say we were right…

Well, this would be helpful for our subscribers who were two years from retirement when we made our prediction… but what about a subscriber who was 25 years from retirement? It’s likely that the 1% rate wouldn’t be accurate for the next 25 years. So if that subscriber used 1%, it would skew his numbers.

For all these reasons, our issue suggested the “yearly checkup,” so to speak. It takes the guesswork out of inflation.

Now, all this said, Mark’s method is correct. And if you want to include an assumed inflation rate in your Magic Number calculations, it’s a good extra “safety” measure.

So we’re including an abridged version of Mark’s original commentary on inflation below. It tells you how to factor inflation into your calculations—regardless of which rate you want to use. We’re also adding it to the asset allocation issue.

You can also click here for our updated Magic Number spreadsheet. It automatically subtracts your assumed inflation rate from your projected rate of return on your investments.

But just remember—there’s a great deal of murkiness around inflation rates. For that reason, the more often you crunch your numbers, the better. It’s crucial in helping keep you on track.

Thanks to our many smart subscribers who write us, helping us address complex matters like this one.

Jeff Remsburg
Editor-in-Chief, Palm Beach Research Group

How Does Inflation Affect Your Magic Number?

by Mark Ford

When planning for your retirement, you have to consider the effects of inflation on the value of your portfolio. That’s because, in most cases, inflation makes future dollars less valuable than they are today. The $80,000 per year we’ve been using in this essay, for example, will still be $80,000 in 10, 20, or 30 years… but it will buy fewer things than it can buy today.

[Inflation is the rate at which the general level of prices for goods and services rise each year. For example, if inflation were 3%, the loaf of bread that cost you $1 last year would cost $1.03 this year. Its price went up… and because it went up, you’ll end up buying less bread this year.]

So how do you account for inflation in your Magic Number planning?

One way is by owning businesses that keep pace with inflation. Companies like this raise their prices to match inflation. Many of the stocks we recommend in our portfolio are of that kind.

Bond yields should increase in the years to come as well. Today, they are low… But these are likely to increase in the years ahead. So that will help, too.

But the main inflation hedge you have in the portfolio I recommended is the rental real estate portfolio. Real estate, as a tangible asset, appreciates during inflationary times.

According to the Case-Shiller index, which has tracked real estate sales of existing homes since 1987, the average annual increase for real estate is 3.6% over this 25-year period. Compare that to the reported Consumer Price Index during the same period, at 2.9%.

More importantly, as a landlord, you should be able to increase your rent to match inflation. I’ve been doing that with my rental real estate portfolio for more than 20 years.

These factors should go a long way toward protecting the validity of your Magic Number. But if you want to be extra sure, you can simply use a smaller interest rate to calculate your Magic Number.

In our existing example, we’re dividing $50,000 by an 8% interest rate (0.08). This gives us a Magic Number of $625,000. But if we want to be more conservative, you could lower your interest rate to 7% (0.07). This would increase your magic number to $714,285.

If you have 20, 30, or 40 years to go before retirement, you might want to use a more conservative interest rate.

Jeff’s note: In our 2015 Asset Allocation Guide, we suggest dividing your Magic Number by 6%. That’s because this is the rate of return you can expect from our “Set It and Forget It” model. Mark’s stated interest rates in his example above (8%, then 7%) come from his original essay, which he wrote before our asset allocation issue.

Has the 2015 Asset Allocation Guide helped you secure your retirement plans? How could we improve it for you? Please give us your feedback, right here.