ARE YOU NOMINALLY OR REALLY ON TRACK TO YOUR RETIREMENT GOALS?
Nominal vs. Real Income Explained
The most familiar use of the terms “nominal” and “real” in describing income is with government and corporate accounting methods. For instance, when a company reports earnings growth of six percent, it is typically stated in nominal terms on its financial statement.
However, when it is measured in real terms, it is adjusted for inflation. The company reports nominal income because it creates a better perception; however, for planning purposes, it uses real income so it knows what its actual capacity is for buying new inventory, producing new goods or hiring new staff.
The same concept applies to consumers, except they generally live in the “nominal” world based on what’s reported in their W-2s and deposited into their checking accounts.
What they don’t see it the effect of inflation on their purchasing power. With an inflation rate of 3 percent, a basket of goods that cost $100 last year will cost $103 this year.
That may not seem like a lot, but 3 percent compounded over means the cost of that basket will double in about twenty years.
The Impact on Savings
The implications of nominal and real numbers become even more significant when they are applied to savings and other interest-bearing investments. Many people are relying upon their savings and investments in bonds to provide a secure source of retirement funds.
As a result of the sluggish economic conditions and the monetary policies of the Federal Reserve Bank, the yields on secure investment have been driven down to near zero. A certificate of deposit may pay 1.5 percent interest in nominal terms; however, in real terms, after inflation, the real rate of return is negative, and that too compounds itself over a period of time.
For many people affected by the economy, it may be bad enough to look at their finances and plan for their future in nominal terms much less having to deal with the reality of real income and yields. But, even those who have not been terribly impacted, looking at their future through nominal lenses can lead to a financial plan that comes up well short of their objectives.
An increasing number of people are having to rethink their retirement plans, and a many of them are not even thinking about retirement in the same terms as they once did. But, whether you expect to retire one day and live off of your savings, or you want to continue to work to maintain your standard of living, your planning needs to consider both the nominal income and investment returns and their “real” counterparts.