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Wednesday, June 19, 2019

Mitigate the effects of inflation on your passive income

Hypothetical:

Say the year is 2019, you have accumulated 2M in investible assets and retired at a ripe old age of 40.


Let's further say you are a somewhat conservative but competent investor, returning an average of 6% on your capital, i.e., 120k a year, or 10k a month.

In 40 years time, at a 2% inflation rate, 10k a month would be more or less be equivalent to having around 5k a month in today's value.

As you can see, inflation is a real issue that wipes out the true value of your passive income, and with that, the goods and services you could reasonably purchase with your income.

In order to ensure that you can enjoy substantially the same purchasing power in 40 years time (at age 80), you will need a mechanism to grow your passive income to outpace, if not match, the inflation rate.

In 40 years, @2% inflation rate, the future value of 10k is around 22k.  Thus, to match inflation, you would need to grow your passive income at a rate to achieve 22k a month passive in 40 years time.

After playing around with some excel sheets, I found that to maintain the present day value of your passive income (assuming a steady 2% inflation rate), you need to re-invest at least 33% of your passive income consistently (assuming a steady yield of 6%).






In other words, even if you return 10k a month of passive income, you should save and re-invest at least 3.5k of that income, so that the value of your retirement nest egg does not diminish over time.

Those who attain FIRE early in their life may scoff at the continued need for savings. They may feel that since their income-generating capital is not being drawn down, they are relatively "safe" since their capital is being "preserved".

However, that fact is, even in retirement, you should provision for a lifestyle that is guided by this 33% re-investment rule and be careful not to over-extend your financial obligations.

Indeed, there is something scarier than CPI inflation, and that is, lifestyle inflation. Once a person has gotten used to a particular standard of living, it is unlikely they would be keen to revert to a less lux life.

Onward to FI friends.


4 comments:

  1. i think it might be very strange to look at still saving in retirement. technically, you are not suppose to be working. i guess the idea is that you have to have more money that is all.

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  2. There's actually a simple formula to calculate the reinvestment rate

    Re-investment rate = Inflation Rate/Investment Returns

    For your example, Re-investment rate = 2%/6% = 33.333%

    Try it out on your excel sheets

    ReplyDelete
    Replies
    1. Ah, very useful indeed. Learnt another new thing today. Much appreciated!

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  3. Excellent post.

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