Inflation over a Forty-Year Retirement: Real versus Nominal Planning and the Rising Floor

What you will learn

• Why a forty-year plan must be written in real euros and how to convert returns.
• Which income sources are indexed, partly indexed or nominal.
• The rising-floor approach: covering essential spending with income that keeps pace with prices and never cutting it.
• How to price a bridge of inflation-protected income.

Explanation

Inflation measurement was covered in the course "Markets & Macro". The withdrawal rates in lessons 2 to 4 are already real rates: the studies assume the withdrawal rises with prices every year. This lesson applies that consistently over up to forty years, where small differences compound into large ones.

Real versus nominal planning

A nominal amount is a number of euros; a real amount is purchasing power in today's euros. The clean method: write all spending in today's euros, use real return assumptions, and set each year's withdrawal to "last year's amount × (1 + measured inflation)". The exact real return is (1 + nominal) / (1 + inflation) − 1; "nominal minus inflation" overstates it slightly: 6 percent nominal with 2.5 percent inflation gives 3.41 percent real, not 3.5. The European Central Bank targets 2 percent, but realised inflation varies widely; the plan must survive runs of higher inflation, not just the average.

How income sources respond to prices

The rising-floor approach

Split spending into a floor (housing, food, health insurance, basic mobility) and discretionary spending (travel, gifts, hobbies). Two rules: (1) the floor is funded by sources that track prices, so it rises with inflation; (2) the floor is never cut in a bad market year; only discretionary spending flexes. This differs from the guardrails of lesson 4, which cut the whole withdrawal. In practice the floor is the statutory pension plus, during the bridge years, a ladder of inflation-linked bonds or a conservative bucket.

Worked example

Hypothetical example: Lena, 55, spends €36,000 a year in today's euros: a floor of €24,000 and €12,000 discretionary. Her statutory pension from 67 is €20,400 a year (gross, in today's euros, assumed to keep its real value through wage indexation). We ignore taxes, health insurance and fees.

Step 1: what inflation does to the nominal number. €36,000 today at 2 percent inflation becomes €36,000 × 1.02^20 = €53,494 in year 20 and €79,489 in year 40. At 3 percent it becomes €65,020 and €117,433. A plan that withdraws a fixed €36,000 forever would, after 30 years at 2.5 percent, buy only €36,000 / 1.025^30 = €17,163 of today's goods.

Step 2: the floor in the bridge years. For 12 years the pension is not there, so €24,000 real per year must come from protected sources. Cost of a ladder of inflation-linked bonds paying €24,000 real for 12 years:

• at 0 percent real yield: 12 × €24,000 = €288,000;
• at 1 percent real yield: €24,000 × (1 − 1.01^−12) / 0.01 = €270,122.

Step 3: the floor after 67. The pension covers €20,400 of the €24,000 floor; for the remaining €3,600 real per year, 25 × €3,600 = €90,000 of the portfolio is earmarked.

Step 4: discretionary spending. €12,000 a year comes from the equity-heavy rest under flexible rules. With €900,000 in total, roughly €900,000 − €280,000 − €90,000 = €530,000 is the flexible pool; €12,000 is 2.3 percent of it, leaving much room to cut or raise.

Step 5: the real-return check. Her broker shows 6 percent nominal; at 2.5 percent inflation that is 3.41 percent real, the figure used in every projection.

Common mistake

Practice activity

Your floor spending is €30,000 in today's euros. (a) How many nominal euros is that in 25 years at 2.5 percent inflation? (b) A deposit pays 5 percent nominal; what is the exact real return at 2.5 percent inflation? (c) A nominal annuity pays €4,800 a year; what is its real value after 10 years at 2 percent inflation?

Key takeaways

• Write the whole plan in today's euros and use real returns; the exact formula is (1 + nominal) / (1 + inflation) − 1.
• Income sources differ sharply in inflation protection: wage-indexed pension and linkers at one end, nominal annuities and cash at the other.
• Fund the floor with price-tracking income, never cut it, and let only discretionary spending flex.
• Price the bridge floor: years × real amount at the current real yield.

Next step

Lesson 10 examines the one product that removes longevity risk completely, the annuity, and compares it honestly with self-withdrawal.