Posted by Tim Stobbs on December 11, 2007
Perhaps one of the hardest things to wrap you head around when planning your retirement is should you do your math in future dollars or today’s dollars? At first I thought it was just a preference. After all working in future dollars for me has always felt a little wrong. I know that a $1 when I’m 45 won’t buy the same thing as a $1 now. So up to recently I’ve always worked in today’s dollars where I take my rate of return and deduct it by the current inflation rate to ensure when I’m spending $24,000/year in 15 years that it is still buying what I think it should.
Yet there is a problem when you always work in today’s dollars. Your sense of progress might be confused when you look at your numbers again in a few years. Your today’s dollar calculation is only valid for the day you calculate the number. After that inflation has altered your spending power.
For example, if you predict your nest egg should go from $75,000 to $100,000 in two years from now in today’s dollars. You won’t know if you are on track two years later, since inflation has been adding to your numbers. You might think you are doing when you have saved $107,000, but in reality you should have saved $111,000 to account for inflation. I know $4000 might not seem like a lot, but magnify that over 15 or 30 years and you can see how big this error can get.
So what is a poor working person to do? Simple keep your overall math in today’s dollars to make sure your spending power is correct, but when you go to outline your milestones you will want to switch over to future dollars and keep your rate of return at its full value. That way your road map should let you know if you are on track or not.
I found this to be a very useful exercise since I’ve been thinking I need a nest egg of around $500,000 when I turn 45 in today’s dollars. Now I realize that number has to be about $250,000 higher when I’m actually turning 45. Has anyone else had problems with their numbers because it this? If so, please share your experience.