How Inflation Erodes Savings (and What Real Returns Are)

You can have the same amount of money in the bank for twenty years and still be poorer. Inflation, the general rise in prices, lowers what each unit of money can buy. The change is slow, which is exactly why it is so easy to ignore. This guide puts numbers on it and shows how to plan around it.

What inflation does to prices

If prices rise 3 percent a year, something that costs $1,000 today costs:

• $1,218.99 in 10 years at 2 percent, $1,343.92 at 3 percent and $1,628.89 at 5 percent
• $1,806.11 in 20 years at 3 percent
• $2,427.26 in 30 years at 3 percent

The formula is future price = price today × (1 + inflation rate)^years. A small yearly rate compounds just like interest, but working against you.

What it does to your money

Turn the calculation around and you get purchasing power. $1,000 in cash left untouched for ten years at 3 percent inflation buys only what $744.09 buys today. After twenty years it buys what $553.68 buys today, and after thirty years, what $411.99 buys today. The number on your account has not changed; what it can buy has fallen by more than half.

Real and nominal returns

A return stated in money terms is a nominal return. The real return subtracts inflation, and it is what matters to your standard of living. The exact formula is (1 + nominal) ÷ (1 + inflation) − 1. With a 5 percent nominal return and 3 percent inflation, the real return is about 1.94 percent, not 2 percent. Over 20 years, $10,000 at 5 percent grows to $26,532.98 in money terms, but that is equivalent to only $14,690.67 in today's purchasing power.

The Rule of 72 for prices

Divide 72 by the inflation rate to estimate how long prices take to double. At 3 percent that is about 24 years (23.45 exactly), and at 6 percent about 12 years. It is a handy way to think about planning: at 3 percent, a lifetime of thirty or forty years sees prices double or triple.

Where inflation hurts most

• Cash and low-interest savings that earn less than the inflation rate.
• Fixed incomes such as pensions and annuities that do not adjust.
• Long-term goals like retirement and children's education, where costs rise over decades.
• Fixed-price contracts where you receive a set amount, for example an unchanging salary.

It can help borrowers: a fixed-rate loan becomes easier to repay in real terms as prices and wages rise.

Planning around inflation

1. Adjust your targets. If you need $50,000 in today's money in 15 years and inflation averages 3 percent, plan for about $77,898.
2. Ask for pay that keeps up. A raise below inflation is a pay cut in real terms.
3. Compare returns after inflation, not before.
4. Use accounts and investments that have a realistic chance of outpacing inflation over your time horizon, understanding that they carry risk. This article is not financial advice.
5. Review regularly. Inflation changes, so revisit long-term plans every year.
6. Keep emergency savings accessible but not oversized, since idle cash is where inflation bites hardest.

Personal inflation differs from the average

Official figures are averages across a basket of goods. Your own costs may rise faster if housing, healthcare, tuition or fuel take a larger share of your budget. If you track your own spending, you can calculate your personal rate: compare what you spent on the same items a year ago with today. Use a higher rate in your planning for the categories that matter most to you.

Try it

The Inflation Calculator has three modes: the future cost of something, the purchasing power of a sum of money, and the average yearly inflation rate between two prices. Turn the future cost into a target with the Savings Goal Calculator. See how real growth builds with the Compound Interest Calculator and the CAGR Calculator, and check whether your salary keeps up with the Salary Calculator. For the growth side of the picture, read how compound interest works.