No matter how often they have been talked about, some threats are so creepy they are worth telling again. Inflation is dangerous not only because it damages your retirement savings, it works so quietly that you may not even notice, until after retiring when you begin to dip into your nest egg.

There are two things that make inflation so invisible. First, it reduces the purchasing power of your asset, not its absolute amount. Red flags do not usually go up if there is no actual drop in the asset value. Second, inflation works slow. The longer you invest, the bigger is its bite on your asset. Because things do not move fast, we cannot see it early enough.

Take an example. It is generally suggested that you will need between 70 and 80% of your current paycheck to live as comfortably after retirement. So, if you earn $80,000 a year today, in order to sustain your current lifestyle after retirement, you will spend about $60,000 a year then. (On the good side, your mortgages may be paid off, kids may be out of college so no tuition cost, social security and Medicare benefits will kick in. On the bad side, medical expenses may hit the roof, among other things.)

How does inflation figure in this estimate? It does not. Assuming you have 20 more years to retire, and a fixed yearly 3% inflation during this time, what $60,000 can buy today will cost you $108,370 (=60000×1.03²⁰) then! So, you will in fact need 135% of your current salary to maintain the same buying power after 20 years.

What if you retire after 10 years, instead of 20? At the same 3% rate of inflation, you will need $80,635 a year then, about the same as you earn today. So, the longer the wait, bigger is the impact of inflation. Money Magazine has recently discussed these issues in this article.

See related posts:

1. Why should we invest?
2. "Real" and "nominal" interest rates