Lifestyle inflation can have a huge impact on your standard of living during retirement. Many investors understand the importance of starting early and making consistent contributions, but fail to account for (or underestimate the impact of) lifestyle inflation.
What is lifestyle inflation?
Lifestyle inflation is essentially the increase in your standard of living over time. Price inflation is associated with the decrease in the purchasing power of your money as prices increase. You can maintain your standard of living as long as your salary increases at the same pace as price inflation. If your salary increase exceeds price inflation then your standard of living may increase accordingly. This, of course, will raise your cost of living. It is thus important to take future price and standard of living increases into account when investing for retirement.
Does a large salary mean an easy retirement?
It’s pretty easy to get used to the new lifestyle that usually accompanies a pay increase and it is this lifestyle that you will wish to maintain going into retirement. If you haven’t accounted for this lifestyle when planning your retirement savings then an increase may have a significant impact on your existing savings and the contributions you need to make moving forward.
As an example: Consider a person who started working at the age of 25 and hopes to retire at 60. Their salary increases have matched inflation throughout their career and they have contributed 10% of their salary to a retirement plan. At this rate (assuming a 6% inflation, an 11% return and 70% salary replacement ratio) they could maintain their standard of living to the age of 94. If they now get a 60% increase at age 45 then they would only be able to maintain their lifestyle to age 79. Due to their more demanding goal and time constraints, they now require an increase of at least 8% to their contributions or they need to defer their retirement by 4 years.
Whether the increase in your standard of living is gradual or once off you will find that the results are similar.
Accounting for lifestyle inflation
Every cent you spend on improving your lifestyle will eventually need to be funded by your retirement savings. You are more likely to achieve goals if you account for any future increases to your standard of living, consider your position at each increase and match your goals and risk appetite with the appropriate asset allocation.
If you feel a bit overwhelmed by all of this then increase your investment understanding by regular reading of investment news articles and consider consulting an independent financial adviser to help you formulate the appropriate