Inflation of contributions and/or expenses

[SecondCor521]

Hi,

I have been staring at my spreadsheet trying to figure out why ER is still so far away even though I'm working hard at it and doing most of the right things.

It dawned on me tonight that I am not being consistent with the way I treat inflation. When I calculate my 401(k) balance, I don't increase my contributions with inflation. But when I calculate my expense, I increase those at the rate of inflation.

For example, suppose I am contributing $500 monthly to my 401(k) and have monthly expenses of $1000. In ten years, my spreadsheet is set up to be contributing the $500 to my 401(k), but my expenses would have increased to $1,343.92 (using 3% inflation compounded annually).

I like to be conservative in my estimation but also reasonably fair. It seems to me I should inflate both or neither.

So for those of you who have your own spreadsheets or have an opinion about this, what do you do?

2Cor521

 

[chinaco]

Bottom line: The more you save now and invest for retirement (and manage it properly), the earlier you should be able to retire.

Most will probably say... if maxing out the 401k lowers your marginal tax rate, max it out. If it does not lower your marginal tax rate, you might consider placing the extra money in a Roth IRA (to the Max) or possibly max out the 401k and a Roth IRA. This will likely reduce your current expenses .

Yes, I would increase contributions with inflation (use my raise) at least. I am maxing both of those vehicles so I cannot increase them. Any spillover goes in a taxable account. Most of my equity mutual funds in taxable accounts are fairly tax efficient.

 

[kcowan]

The other thing about inflation is to use a real world number. I started with CPI but now I use 5% and also run an alternate case at 6%.

 

[justin]

I usually use 3% for inflation. I inflate my expected contributions to 401k/IRA/taxable savings by inflation+1% usually (assuming my earnings and therefore ability to save/invest will increase at a rate slightly above inflation).

Expenses I inflate at 3%. Except education and healthcare, which I inflate at something like 5-6%.

It seems pretty safe to assume your salary will increase at least as fast as the rate of inflation, so assuming your expenses stay constant (in real terms), then you should still have enough money left over at the end of the month to increase your 401k (or other investment contributions) at the rate of inflation.

The main thing is to be consistent. Sometimes I'll make "quick n dirty" calculations where I calculate everything in real terms ignoring inflation.

 

[Sandy]

If you aren't at you limit and you expect to increase your contribution, then you should project increases.

But, if you max your contribution, don't the feds have to raise the contribution limit for 401(k)? Then you can't assume you can increase the contribution based on inflation - since you can't assume the feds will raise the contribution limit.

 

[justin]

But, if you max your contribution, don't the feds have to raise the contribution limit for 401(k)? Then you can't assume you can increase the contribution based on inflation - since you can't assume the feds will raise the contribution limit.

The latest tax legislation has linked 401k limits to the inflation index (CPI I think). So it stands to reason that even if you currently max out the 401k, you can still expect to increase your contributions at the rate of inflation (on average). The 401k limits will increase in $500 increments, so there might not be an increase in the limit every year, but on average it should increase at the rate of inflation.

 

[W2R]

I max out my 401K (TSP) contributions every year, including my "over-50 catchup". Last year I put in $20K ($15K + $5K over-50), and this year it's $20.5K ($15.5K+$5K over-50). I am figuring on an increase of $500 per year, but will contribute whatever is the max. Anything extra after my TSP and other expenses goes into my taxable nestegg.

As far as expenses go, I have been living on what I feel is a very minimal amount for me. My recurring (non-"emergency") non-mortgage expenses were down to $600/mo before Katrina. After Katrina, the cost of living here went up sharply and my expenses went up to $800/mo, plus I had to pay for at least some materials to repair hurricane damage to my property. Panic!!

Well, all's well that ends well. I got a couple of cash awards, and then a promotion, and finished paying off my house, and now I can handle the increased cost of living and save even more than I had planned on saving (in my spreadsheet). Even better, costs at last seem to be going back down at least part of the way now that goods and most services are easily available.

I think flexibility for coping with changes that we can't control, and enough self-honesty to correctly identify what we can and can't control, are necessary in a realistic plan. The important thing is to stay focused on the goal and to do what you must in order to get there from wherever you are.

 

[SecondCor521]

Thanks to all for your comments.

A few clarifications:

1. The $500 and $1000 numbers in my original post were arbitrary example figures. The actuals are different; I'm keeping my specific actuals private for now.

2. I am under the $15.5K federal limit this year as a consequence of my divorce late last year and the resultant turmoil. I also have a Roth, traditional IRA, and my kids' college accounts. This year I have maxed the Roth and my kids' 529 and ESA accounts. I know this violates the commonly given guidelines, but given the turmoil it was easier to do it this way. I also get no (zero, nada) employer match on my 401(k). Taxwise I am in the 25% federal marginal bracket, and don't think I could predict where I will be in future years.

3. I did change my spreadsheet to increase my contributions with inflation, but it surprisingly made little difference. Personally I use 3% to inflate expenses and 401(k) contributions, 5.25% for short-term savings, college expenses at 6%, and investments at 10.7% (using the long term Ibbotson number).

4. At this point I don't increase my contributions or savings rate because at this point my job is just being a contractor, and there are no raises in the future. I do hope soon to get on permanently with the company I work at, and am hoping/thinking I will get a 20-30% raise at that point.

2Cor521

 

[Sandy]

The latest tax legislation has linked 401k limits to the inflation index (CPI I think). So it stands to reason that even if you currently max out the 401k, you can still expect to increase your contributions at the rate of inflation (on average). The 401k limits will increase in $500 increments, so there might not be an increase in the limit every year, but on average it should increase at the rate of inflation.

Thanks for the clarification.

 

[figner]

Expenses and contributions more than 10 years out probably have large error bars anyway. To keep things simple, I don't inflate expenses or contributions in my spreadsheets. I assume my salary will roughly keep pace with inflation, and subtract an expected inflation rate from my estimate of average portfolio returns, i.e. if I thought my return would be 9% with 3% inflation, I'd run the numbers using 6% returns. That keeps everything in today's dollars which I find easier to think about.

 

[SecondCor521]

figner,

Hmmm. I'm just the opposite, I prefer to use nominal/future dollars for everything. I think it does cause some confusion here on the board sometimes, though. For young dreamer types, saying you need $2M to retire means different things in current dollars vs. future dollars. Of course, lifestyle differences make a big difference anyway.

I agree with you on the error bar thing, but I think it's worth the effort to do the modeling for the side benefits it provides - being able to do "what ifs", considering whether to pay off the mortgage based on a target retirement date, etc.

2Cor521

 

[figner]

Yeah, it's just personal preference I guess. One reason I like using current dollars is that my FIRE date is still uncertain. Feels weird to be constantly thinking stuff like "Ok, if i RE in 20 yrs I'll need $3mil, but if I retire in 10 yrs it's $2mil."

If I were less lazy I'd probably also find it interesting to model things like different inflation rates for healthcare, etc. As it is I just adjust my rate of return to account for what-ifs...

 

[Rustic23]

Let’s say in and excel spread sheet cell a1 is your expected living expense now. Say $1,800 a month. You thin inflation will be 4%. Enter this in cell a2 ‘=(a1*.04)+a1’ then copy and paste it as many times as you want. Say for 35 rows. You will see that in 35 years you will need $6,829.77 to live on. That is $81,957.24 a year or at 4% SWR $2,048,931. This can be repeated for a number of figures.

OK, I know that was a little basic for those of you that are Excel experts, but I thought I would give a basic method. There are functions in Excel that will generate the same numbers.

 

[GoodSense]

I do exactly the same as Figner. It's just so much easier to think I'll need something like $1 to $1.5m to FIRE today than some astronomical number 20 -30 years later. I also subtract about 3% from the expected return to account for it. The only thing that is confusing is the mortgage, since I don't know if the value of the house will go up with inflation, stay flat, or (hopefully not) drop. (I'm one of those who plan to move after ER) Since it's still a ways into the future, I'm not too worried.

 

[Webzter]

I talk about everything in current dollars. So, if I say that I need $1mm to retire and will retire in 10 years, I mean that I'll need $1mm in today's dollars.

To make looking forward easier, I just work out a real return for planning (for instance, a 3% real return based on 4% personal inflation and 7% return (conservative planning I guess))

Confusing I suppose, but it seems much more straightfoward in my head than on paper.

Back to the question about 401k contributions, I just adjust up to the max.

 

[Webzter]

2Cor521,

Justin hit on it earlier in the thread and it just occured to me this morning as well.

Assuming that you're contributing a percentage of your paycheck (say, 5%), and not some arbitrary dollar amount ($500), and assuming that you're receiving annual pay raises at least on par with inflation, then your contribution is automatically increasing with inflation as well.

So, the better model for your spreadsheet might be to include expected pay raises as well and assume they're at least on par with CPI.

 

[kaudrey]

I increase expenses by 3% and the 401K by 2%. The 2% basically implies that I expect the gov't to raise the limit by $500 every 2 years or so (more often in later years, but I'll adjust each year based on what they actually do).

I max out my contributions, so this basically smooths out what I might be able to contribute.