Inflation is another one of the things that can go wrong with needs based planning. Inflation is when the general price of goods and services goes up over time. When the price of goods or services goes up it means that each unit of currency can buy less. Inflation erodes the purchasing power of money and any return on investments. For example, if you are able to earn 10% interest, but inflation is 4%, your inflation adjusted rate of return is 6%. Underestimating inflation can cause a person to think they need less money for retirement than you actually do. If someone is using needs based planning and they underestimate inflation, their expenses during retirement will be more than they expected. Even if they meet their original retirement goal, they still will not have enough for retirement.
In recent history inflation has been pretty stable, but looking back only 30 years you can tell that inflation is anything but stable. Between 1979 and 1981 (3 years) annual inflation was above 10% peeking at 13.58%. In 1947 it was 14.65%, and between 1917 and 1920 (4 years) it was above 15% peeking at 17.5%. So as you can see inflation can creep up out of nowhere.
There are a few different things that can cause inflation, but one of the major factors involved is the amount of money in circulation and the rate at which that amount increases. Since the late 1960’s the money supply of the United States has been growing very significantly. In the last few years we have more than doubled the money suppy. I can’t imagine how we are not going to have inflation problems in the near future. The only reason why we haven’t experienced the full effect of the increased money supply is because it hasn’t all gotten to the public yet. I’m not a doomsday kind of person, so I won’t go as far to say that we will have hyperinflation, which destroys almost all value of your money. However, I have a hard time figuring out any other scenario than at least 10% inflation in the next 5-10 years.
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