Inflation and real returns: what your money will actually buy

A projection that ends at 143,587 € tells you almost nothing on its own. In thirty years that figure buys what a much smaller amount buys today, and the gap is large enough to change decisions. This guide shows how to convert a nominal return into a real one, what the conversion costs over ten, twenty and thirty years, and the simplest way to keep a whole plan in today's money.

Nominal and real: two different questions

A nominal return answers "how many euros will I have?" A real return answers "how much will those euros buy?" Both are correct; they answer different questions, and mixing them is the most common error in long-term planning.

Everything a bank or fund quotes is nominal. Inflation is not deducted anywhere, because the provider has no idea what your inflation will be. Converting is your job, and it takes one line of arithmetic.

The conversion, exactly

real = (1 + nominal) / (1 + inflation) − 1

All three as decimals: 6 % = 0.06

6 % nominal with 2 % inflation: 1.06 / 1.02 − 1 = 3.92 %

Not 4 % — the shortcut of subtracting overstates the real return

This is the Fisher relation, exact rather than approximate

The difference between 3.92 % and the subtracted 4 % looks trivial. It sits in the exponent, so over thirty years it is not: on 25,000 € the shortcut overstates the result by roughly 1,850 €. Use the division. It is not harder.

What 2 % inflation does over thirty years

25,000 € invested once, 6 % a year, credited annually. The first column is the balance in future euros; the second is the same balance expressed in today's purchasing power.

Over thirty years, 45 % of the nominal balance is an illusion. The money is there, but it does not buy what the number suggests. Anyone comparing a projection against a goal stated in today's prices — a house, an annual income, a car — has to make this correction or the comparison is meaningless.

The shortcut and when it is safe

Subtracting inflation from the nominal return is the standard mental shortcut, and it is a good one — within limits.

• At low inflation and short horizons the error is negligible. Ten years at 2 % inflation: the shortcut is off by about 280 € on 25,000 €.
• The error grows with the horizon, because it compounds. Thirty years: around 1,850 €.
• In the rate itself the error is roughly the real spread times the inflation rate, so it grows with both. At 6 % nominal and 2 % inflation it is 0.08 percentage points; at 15 % nominal and 10 % inflation it is 0.45.
• For anything you will act on, use the division. Reserve the shortcut for conversation.

Two ways to model it, one of them better

You can either keep everything nominal and deflate the answer at the end, or work in real terms throughout. The second is much easier to keep straight.

1. Decide the inflation assumption and write it down next to the plan. Two percent is the European Central Bank's target and the usual anchor for the euro area.
2. Convert your nominal return to a real one with the division above.
3. Enter the real rate in the calculator and leave contributions and withdrawals at today's amounts.
4. Read every figure in the result as today's purchasing power. No further correction is needed.

The one thing this approach assumes is that your contributions rise with inflation. If you enter 400 € a month in today's money, you are implicitly promising to pay in 400 € of purchasing power every month — which means raising the nominal amount over time. That is usually what people intend, but it is worth being explicit about.

Where inflation hides in a plan

Inflation does not only shrink the end balance. It affects three inputs, and two of them are easy to miss.

• The target. A goal of 500,000 € for retirement in thirty years is a goal of roughly 276,000 € in today's money at 2 % inflation. Decide which one you meant.
• The contribution. A nominally fixed monthly amount falls in real terms every year. Over thirty years at 2 %, a flat 400 € ends up worth about 221 €.
• The withdrawal. This is the sharpest one: a flat retirement income is a shrinking retirement income, and the shrinkage runs for as long as the retirement does.

What to take away

• Quote your own plans in real terms. It removes a whole class of error and makes the numbers comparable to prices you know.
• Use division, not subtraction, whenever the horizon is longer than about ten years.
• State the inflation assumption explicitly. An unstated assumption is the one that turns out to be wrong.
• Remember that fees and taxes come off the same return. A 6 % nominal return, 2 % inflation and 0.5 % annual costs leave roughly 3.4 % real — and that is the number your plan actually runs on.

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