When we are planning a shift away from 9 to 5 work it is important to consider how our plans will stand up to the test of time. If you have ever seen an old Coca Cola sign saying "Ice Cold Coca Cola 5¢" then you've seen what inflation can do. If my financial plan 50 years ago was to put $5 under my mattress so that I could buy 100 bottles of Coca Cola today, I'd be in for a big surprise when I dropped into my local convenience store. Today I could probably only get 2 bottles with my $5. So to avoid running into a similar shock down the road, let's take a look at inflation to see what we need to do to deal with it.
We'll start things off with a diagram showing the main concepts and the we'll go over things in more detail.
Inflation is the natural tendency for the cost of things to go up over time. There are several economic theories that try to explain why inflation happens but for our purposes today we just need to understand that it does happen. So gradually, all around us, the price of things is increasing. This means that the purchasing power of each dollar is going down over time. So to be able to afford our present standard of living in the future, we'll need more money than we do today.
We often talk about inflation "eroding our savings" or "cutting into our returns," but it is important to understand that inflation doesn't physically take our money. If you put a $100 bill under your mattress you will still have that $100 bill 20 years later. The problem is that that same $100 bill won't be able to buy as much as it did when we first put it under the mattress.
Well, it is impossible to know for certain what the rate of inflation will be in the future, but typically an estimate of 3% each year is fair. So, $100 of stuff today will generally cost $103 next year. In some years inflation is higher than in others but for the purposes of our planning, an estimate of 3% should ensure that we don't run into any problems.
If you are interested in playing around with historical numbers, the Bank of Canada has an online inflation calculator that lets you see how inflation has affected the value of money over time. I just checked and $1000 in 1914 is about the same as $18,000 in 2007. So inflation definitely matters!
Now that we know that inflation can gradually erode the value of our money over time, what can we do about it? The number one thing that we can do is invest our money. We need to invest our money into something that will give us a higher rate of return than inflation. So although keeping your money under your mattress might seem safe, it isn't. Inflation steals a little bit each year as long as it is not invested.
A good rule of thumb when looking at a potential investment is to figure out your expected annual rate of return and subtract 3% to account for inflation. So, for example, a high interest savings account that pays 4% interest is giving you a total return of 1% after inflation. This ensures that $100 invested today retains its value so that in 10 years we'll still be able to buy the same amount of stuff that we could today. If a potential investment is paying less than our 3% inflation estimate then there is a risk that our money will grow more slowly than the cost of living. So if you've got all your money in a chequing account that pays 0.05% interest then you are at risk of losing out to inflation in the long run.
The main thing to remember is that you should not ignore the effects of inflation when you are putting together your escape plan. If you are creating an income generating portfolio you should aim for investments that increase their payouts by at least the level of inflation over time. By always considering the effects of inflation we can help ensure that our escape plan is built to stand the test of time.