Inflation and Real Return

Nominal vs real return

Nominal return is what your investment account shows—the raw dollar amount. For example, if you invest $100,000 and it grows to $200,000, your nominal return is 100% (or $100,000). Real return adjusts for inflation and reflects purchasing power—what your money can actually buy. If inflation was 3% per year over that period, your real return is lower because $200,000 in the future buys less than $200,000 today. The key insight is that inflation erodes purchasing power over time. A 7% nominal return with 3% inflation gives you a 4% real return. This is why real return matters more than nominal return for long-term planning—you care about purchasing power, not just dollar amounts.

How to calculate real return

The formula for real return is: Real Return = [(1 + Nominal Return) / (1 + Inflation Rate)] - 1. For example, if your nominal return is 7% (0.07) and inflation is 3% (0.03), real return = [(1.07) / (1.03)] - 1 = 1.0388 - 1 = 0.0388, or 3.88%. For quick mental math, you can approximate: Real Return ≈ Nominal Return - Inflation Rate. So 7% nominal - 3% inflation ≈ 4% real. This approximation works well when rates are low (<10%), but the exact formula is more accurate. The key is to use the same time period for both returns and inflation (usually annual).

Why it matters for retirement planning

Inflation compounds over decades and can dramatically reduce purchasing power. For example, at 3% annual inflation, prices double in about 24 years. So $1 million in 24 years has the same purchasing power as $500,000 today. This is why planning retirement in nominal dollars is misleading—if you plan for $2 million in 30 years, that might only buy what $1 million buys today (at 2.4% inflation). The most common retirement planning mistake is using nominal returns without adjusting for inflation. You might think 'I'll have $2 million, that's plenty,' but if inflation averages 3%, that $2 million will only buy what $860,000 buys today. Always plan in real (inflation-adjusted) terms to get an honest picture of your future purchasing power.

Inflation's compounding effect

Inflation compounds just like investment returns, but in reverse. At 3% annual inflation: After 10 years, prices increase 34% (1.03^10 = 1.344). After 20 years, prices increase 81% (1.03^20 = 1.806). After 30 years, prices increase 143% (1.03^30 = 2.427). This means $100 today buys what $243 buys in 30 years (at 3% inflation). The longer your time horizon, the more inflation matters. For retirement planning (30-40 year horizons), inflation is one of the biggest risks. Even 'modest' 2-3% inflation can halve purchasing power over 25-30 years. This is why you need higher nominal returns to maintain purchasing power—if you need 4% real return and inflation is 3%, you need 7% nominal return.

How to use real return in planning

Use real return for all long-term planning: (1) Retirement planning: Calculate how much you need in today's dollars, then use real returns to project growth. For example, if you need $50,000/year in today's dollars and expect 4% real return, you need $1.25 million (using the 4% rule). (2) Investment comparisons: Compare investments using real returns, not nominal. A 6% nominal return with 2% inflation (4% real) is better than 7% nominal with 4% inflation (3% real). (3) Goal setting: Set goals in today's dollars, then adjust for inflation when projecting future needs. (4) Scenario analysis: Model different inflation scenarios (2%, 3%, 4%) to see how sensitive your plan is. (5) Withdrawal strategies: In retirement, withdraw based on real returns, adjusting for inflation each year.

Common mistakes

Common mistakes with inflation and real return include: (1) Planning in nominal dollars—always use real (inflation-adjusted) dollars for long-term planning. (2) Ignoring inflation in retirement planning—this is the #1 mistake. $1 million sounds like a lot, but in 30 years it might only buy what $400,000 buys today. (3) Using historical returns without inflation adjustment—'stocks return 10%' is nominal; real return is about 7% (with 3% inflation). (4) Assuming inflation stays constant—it varies, so model different scenarios. (5) Not adjusting withdrawal rates for inflation—if you withdraw $40,000/year, you need to increase it by inflation each year to maintain purchasing power. (6) Comparing returns without inflation context—a 5% return with 1% inflation (4% real) is better than 6% with 3% inflation (3% real).

Worked Example

Edge Cases & Special Situations