It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

—Henry Ford

If you read part 1 of this series, and thought to yourself, hm, they didn’t account for inflation, congratulations. You’re right. It’s a pretty glaring omission, I know. Everyone knows you have to account for inflation.

I’m sure you know how this story ends, but let’s go ahead and go through the motions, anyway. If you recall, our contribution rate was $1200 per year, from ages 22 to 65. We found out last time that using the more accurate CAGR instead of “average” return, we wound up with a little over $600,000 instead of the $1 million we were promised. Now let’s factor in inflation. As it turns out, the inflation-adjusted CAGR of the stock market from 1900 through 2011 works out to just 6.26%. Heading over to the retirement calculator and plugging in our new 6.26% “real” return, we wind up with only $241,751. Ouch. So much for our million-dollar retirement.

No surprises, here, right? But there’s a problem. You see, this figure is pretty much bullshit as well. To understand why, we need to look into what inflation really is, and how it’s measured.



What is Inflation, Exactly?

Strictly speaking, inflation is an increase in the total amount of money in circulation. Rising prices are just a side effect, reflecting the loss of purchasing power you get when there is more money chasing after the same amount of goods and services.

Most people don’t think much about abstractions like the total amount of money in circulation, though. They think about the price they pay for milk at the grocery store. That’s why when most people think of inflation, they are really thinking of something called the “cost of living.”

What is the Cost of Living, Then?

So what exactly is the “cost of living?” When most commentators from the government or the business community use the term, they are referring to something called the Consumer Price Index, or CPI. This figure is published periodically by the Bureau of Labor Statistics, and represents the government’s official position on what the rate of inflation is. It’s also what’s used to generate all the “inflation adjusted” returns you’ll see reported all over the Internet for every sort of asset (including the “real” return for the stock market I quoted above).

The thing is, the BLS itself states quite plainly that the CPI is not intended as a model for the cost of living, and you should take that to heart, because the odds that the CPI accurately represents your cost of living are slim to none.

What’s Wrong with the CPI?

If you wanted to model changes in the cost of living, chances are you’d put together a list of products and services used by a typical American family. You’d then add up prices from one year to the next, weighted for how much of each item people consume on average per year. Subtract the previous year’s result from this year’s, and you have your rate of inflation.

Makes sense, right? The trouble with this is assuming that there’s such a thing as the typical American family. If you don’t watch TV, for example, you don’t care if flat-screens are getting cheaper. If you’re a vegan, you don’t care if steaks are getting more expensive. This can mean that changes in your personal cost of living can vary wildly from what the CPI reports.

For some examples, let’s have a look at the weightings for 2011 in the CPI-U, which focuses on people who live in urban areas. “Food away from home” is weighted at nearly 6% of a family’s budget. I’m sure this is accurate on average, but what if you live a frugal lifestyle and rarely if ever eat out? Similarly, transportation is weighted at 17% of the average budget. What if you bike and walk everywhere, don’t own a car, and rarely take public transit?

Housing costs are especially troublesome. They are weighted at a whopping 41%, but price trends for these can swing hugely in either direction depending on which part of the country you live in. Housing prices in the DC area, where I live, for example, did not see anywhere near the decline that other parts of the country experienced during the subprime meltdown. Furthermore, you may well plan on moving to a much less expensive area when you retire. And naturally, if you have a paid-off home, your housing expenses are going to be very different than a renter’s.

In short, you should plan your retirement based on the choices you will make, and the lifestyle you want, not what the government estimates a “typical” household will do. Stay tuned to learn how to do precisely that.

Note 1: The real situation is even worse, for the $241,751 figure assumes you adjusted your contributions for inflation, which was not part of the original plan laid out in part I. The real result you’d receive if you didn’t adjust can’t be computed without knowing the particular years in question, but would be far lower.

Note 2: The original version of this article included a discussion of changes over the past few decades to the CPI calculation methodology due to the findings of the Boskin Commission. After receiving some feedback, I realized I had relied on some poor sources, and the discussion was thus overly simplistic and potentially misleading. The issue was ultimately beside the point, in any event, so I removed it.