The importance of inflation in your net worth projections
By Mike Winsor, CFP® 19 September 2023 2 min read
One of the most common tools used in financial planning conversations is the projection of net worth over time.
While this is an essential part of a financial planning conversation, it can be easily misunderstood if not properly analyzed. This article discusses how inflation should be considered when conducting net worth projections.
Being able to determine your projected net worth requires understanding projected purchasing power over time, and these concepts are not one and the same. That’s because of the effects of inflation. A dollar in the future will not be able to purchase as much as a dollar today.
For example, let’s say you have $1 million in cash today, and hold that over your lifetime with no growth. If a loaf of bread costs $3, you could purchase 333,333 loaves today. If we assume 2% inflation on the price of bread over time, we see the following:
|Price of bread
|Loaves of bread purchasable
|20 years from now
Even though the amount remains the same, you can now only purchase about two-thirds of today’s amount. This loss of purchasing power is important to consider when looking at your net worth over time.
Let’s look at how the purchasing power of a million dollars can change over 30 years depending on growth rates. To do this, we’ll compare net worth in future dollars against net worth in today’s dollars (purchasing power). Purchasing power can be arrived at by discounting future net worth by inflation:
1. Your net worth stays the same over time (0% growth, 2% inflation)
This means that your purchasing power is actually declining over time (to the point where it is almost halved in 30 years). So while your net worth will stay the same, the erosion of purchasing power could significantly impact your future lifestyle.
2. Your net worth increases over time, but at a slower pace than inflation (1.5% growth, 2% inflation)
In this scenario, your purchasing power is also declining, though at a slower pace than the first scenario.
3. Your net worth increases over time at a slightly faster pace than inflation (2.5% growth, 2% inflation)
This means that while your net worth may appear to be increasing rapidly, your growth in purchasing power will not be happening as rapidly as expected. You may only be preserving your purchasing power rather than significantly increasing it.
Understanding the impact of each of these scenarios will be important when it comes to retirement planning and determining a realistic budget.
The concept of adjusting returns for inflation is also commonly applied to investment planning. This is referred to as the “real rate of return.” You can estimate your real rate of return by looking at your expected rate of return and reducing it by the expected rate of inflation. Planning around your real rate of return can help limit the risk of unexpectedly running into the scenarios above.
The best way to limit the impacts from these scenarios is to keep your financial plan up to date and periodically review it for updated long-term inflation rates. This will help you to not only monitor your net worth, but also your projected purchasing power over time.
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