Kitchen Table Planning - Real Rate of Return

When you are working on your kitchen table plans, you will need to understand real rates of return. Your real rate of return is simply your investment return less the anticipated inflation rate.

For example if you have calculated your expected portfolio return at 8% and you anticipate that inflation will average 3% then your real rate of return is 5%.

This is important because over long periods of time inflation will erode the value of the dollars you have available to pay for a financial goal. If you are planning for retirement the dollars you will need to provide a certain level of income 20 years from now will be significantly higher than the dollars you need to retire today. If in fact inflation averaged just 3% over the next 20 years then todays dollar would only buy $0.55 worth of groceries when you reach retirement.

I see this often. Someone will say 'I have $500,000, I think I should be able to earn 8%, so I should be able to spend $40,000 each year.' Unfortunately this isn't how to achieve a worry free retirement. If you earned 8% you would have to reinvest 3% to offset inflation leaving you with 5% to spend. So the couple in the above example could only take an income of $25,000 from their $500,000 nest egg.

Or you may say 'I will need $1,000,000 to provide extra income in my retirement. How much should I be saving each year to end up with $1,000,000 when I retire?' Here you must use your real rate of return to calculate the payments required to reach your goal because you want to achieve the purchasing power of $1,000,000 today at some point in the future.

It is sometimes hard for folks to grasp this concept, but to come up with any real financial plan you must understand and know when to use real rates of return.