Inflation: Using real vs nominal rates of return
Recently, I wrote about using different rates of return for retirement projections. Instead of using just one return which is a big giant guess that is guaranteed to be wrong, you are better off using multiple returns to see the range of possibilities based on a worst, best and middle of the road return.
When it comes to inflation, there is a very important distinction between real returns and nominal returns. Let’s look at what these terms mean.
What is a real rate of return?
A nominal return is simply what people call a gross rate of return or the actual return. The real return is simply the gross return less inflation.
In 2010, the TSX gave Canadian equity investors a whopping 17.6% return while bond investors still got a respectable 6.7% return. Given that inflation was 2.4%, the real returns were 15.2% for equity investors and 4.3% for bond holders.
Is it better to use real returns or nominal returns for your projections?
Regardless of which approach you use, you have to factor inflation into any retirement projection. The purchasing power of $1 thirty years ago is different that today. I remember as a kid, my sister and I could go into a store with one dollar and get 2 chocolate bars, a bag of chips and a handful of double bubble. Today, if I took two of my kids into the store I could barely get out with just a five dollar bill for those same items.
From an investment perspective $100,000 portfolio is different today than it was 20 or 30 years ago simply because inflation changes the value of money.
When I run retirement projections, my preference is to use real rates of return with an inflation rate of 0% instead of using nominal returns and an absolute inflation rate. Both projections should arrive at similar conclusions but I prefer the real rate of return scenario because it just makes the numbers more understandable. Let’s look at a case study
Ivan and Sheree
Ivan and Sheree are 35 and want to retire in 25 years. Let’s say they have $100,000 in investments and are able to put away $750 per month. If we assume a nominal rate of return of 6% and an inflation rate of 2%, how much will they have at retirement?
If we use the nominal return approach, they will have $660,793 in 25 years. At a 4% withdrawal rate, this will produce an income of $26,431 per year of gross income.
If we use the real rate of return approach, they will have $491,994 in 25 years. Their income based on the same withdrawal rate is only $19,679 per year.
Although it would appear better to have $660,793 instead of $491,994 they are actually the same (not quite but close) amount of money when you take inflation into account.
The difference is the $491,994 and the $19,679 income is a better reflection of today’s dollars. It makes the numbers easier to relate to. It’s kind of like the goal of having $1 million dollars. Although a million dollars is a lot of money, it’s not the same value as having $1 million dollars 30 years ago. A million dollars today was like having $550,000 30 years ago.
Regardless of which approach you use, the message is simple …. you must account for inflation in your retirement projections. If you use nominal returns, then you have to factor inflation. If you use real rates of return, then inflation is factored in already.
What method do you prefer to use for your retirement and financial projections?