3 Steps To Best Inflation When Planning For Financial Independence​ - The Art of FI (2024)

• S.A. FI
• August 17, 2022

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However, this day it was different. When I went to pick the apples, I noticed the price was now $1.25/pound. I thought, “Man, the price of the apples has gone up! Is there a cheaper option?” Nope, the Red Delicious was still the cheapest option.

Why did the price of the apples go up?

The sudden increase of 26% on the price of apples may be an exception as recent economic difficulties are causing the price of food to increase. However, it is natural and healthy for the price of goods and services to naturally go up as time goes on. This is called inflation.

I remember as a kid growing up my parents paying $0.99/gallon for gas or when a movie ticket was $5 or even less.

Just look at the following chart from HowMuch.net where it shows how the price of consumer goods have changed in the 20-year period from 1998 to 2018:

This chart shows some products became cheaper (e.g., televisions, toys, software, and cell phones) in the past 20 years while some stayed pretty close to the same (e.g., cars, apparel, and furniture) as it relates to purchasing power.

This does not mean the exact price has stayed the same. For example, according to Cheapism, the price of a new vehicle in 1998 was $20,218 and in 2018 was $25,130. When accounting for inflation, the price of the vehicle increased about 1% per year which is in line with the chart above.

How does this relate to financial independence?

Let’s say, for example, you are a single 25-year-old, and your Financial Independence Number is $1 million. If you max out your 401k ($23,000 in 2024), max out your Roth IRA ($7,000 in 2024), max out your HSA contribution ($4,150 in 2024), and save an extra $2,000 per month from reducing your expenses, then you will be saving $58,150 a year. Great Job! Where are you going to invest the money?

An average savings account historically averaged about 0.06% per year and will take you about 19 years to save your $1 million. This is almost equal to stuffing your money underneath your mattress for 18 years. (Note: Even though savings accounts in 2023 could offer interest rates upwards of 5%. When the Fed starts to lower the interest rates, then we’ll see these rates drop off.)

Let’s say you put it in a high-yield savings account which historically earned you 1.50% per year. This will reduce your savings time a whopping two years to 16 years.

You may be saying to yourself, “Self, you are going to have $1 million in 16-18 years. That’s more money than I’ve ever seen. I can totally live off that!”

What if I told you that your $1 million in 16-18 years would lose 40% of its purchasing power by leaving it in a bank account? What this means is your money, even though you have $1,000,000, will be worth 40% less. Would you still be happy to save all that money into the savings account for nearly two decades?

Because of this long period of time for you to save for financial independence, inflation is going to play a larger role in your savings. Inflation is the general increase in the price of goods and services over time.

The U.S. economy has historically averaged 2%-3% inflation per year. By putting money in your savings account or mattress, your $1 million goal will now need to be between $1.43 million to $1.7 million after 18 years to equal $1 million today. This is a 43%-70% increase from your original goal! Basically, you are not going to be able to keep up with inflation by saving in a bank account. Your money is worth 2-3% less every year, so you need to either increase the savings amount or your investment returns to keep up.

Inflation is one of the primary reasons why we promote the importance of knowing your inflation-adjusted Financial Independence Number and not just setting a simple financial goal. Even if your goal is to retire in five years, inflation will still play a role on the Financial Independence Number. This is because your Financial Independence Number will need to grow at the same rate as inflation to maintain the same lifestyle as you set out for in your financial independence life.

When calculating your inflation-adjusted Financial Independence Number, you will add 2%-3% compounded annually each year you are saving for financial independence. For example, if you decide you need $1,000,000 in today’s dollars to reach financial independence, then you will need the following inflation-adjusted amount based on the number of years you are to the goal:

As you can see from this chart, inflation over time increases the amount you need to save. Even when planning to reach financial independence and make work optional in five years, you will need to save an additional 10.4% above your $1,000,000 target assuming 2% inflation. If inflation were at 3%, then you will need to save an additional 15.9%. Remember, these are just averages. From now until when you decide to retire or make work optional, inflation could be much higher or much lower than these numbers.

In summary, inflation is one of the primary reasons you must continue to grow your savings after you retire or make work optional. If you decide to go extremely conservative and put too much of your investments in bonds or a savings account that doesn’t keep up with inflation, then your purchasing power continues to decrease even though you are preserving capital.

Action Items

1. Understand how inflation affects your savings and savings rate
2. Calculate your inflation-adjusted Financial Independence Number and not the number you need today
3. Create a Financial Independence Plan to stay ahead of inflation even after you retire or make work optional

Discussing how to improve your personal finances is one of the things I discuss in myFREE Financial Independence Plan Frameworkguide that you can download below.

If you are serious about financial independence or are still thinking or learning about it, then you should get this free download. What do you have to lose? It’s FREE!