real return and inflation adjusted thinking

In short

A friend of mine once bragged that his savings account earned him $300 last year, and he beamed like a man who had struck oil. I did not have the heart to tell him that his groceries cost him more than that extra, so I will tell you instead. If you are holding money for a long term goal, the number on the statement is only half the story. What counts is what that money can buy when its owner finally spends it. The earnings rate minus the rate at which prices are climbing gives the real return. That figure can be worked out for any savings or investment, and once a year is often enough. Done that way, a person sees money the way the grocery store sees it.

The whole of it

What it is

I once watched an old farmer count his corn crop twice, first by the bushel and then by what the bushels would fetch at the feed store. The two counts told different stories, and he trusted the second one. That is the heart of real return. A nominal return is the plain percentage your account shows, before anything else is considered. A real return is what is left after you subtract inflation, which is the general rise in prices over time.

You have probably noticed that a dollar does not stretch as far as it did when you were younger. A loaf of bread, a tank of gas, a visit to the doctor all cost more now. Inflation is the name for that slow creep. So when your money grows by 5 percent in a year but prices also rise by 3 percent, you did not really get richer by 5 percent. You got richer by about 2 percent in what your money can buy.

Think of it like a boat on a river with a current pushing it back. If you row at five miles an hour and the current pulls you back three, you move forward two. Nobody is judging your rowing. The river is simply moving too.

How it works

A neighbor of mine keeps his emergency money in a savings account and sleeps well, and there is wisdom in that. But it helps to know the arithmetic underneath. The rough method is subtraction. Take the nominal rate and subtract the inflation rate. If an account pays 4 percent and inflation runs 3 percent, the real return is about 1 percent. If an account pays 2 percent and inflation runs 3 percent, the real return is about negative 1 percent. That means the money buys a little less each year, even as the balance grows.

The subtraction is a shortcut. The exact method divides instead. You take 1 plus the nominal rate, divide by 1 plus the inflation rate, and subtract 1. With a nominal rate of 6 percent and inflation of 3 percent, that is 1.06 divided by 1.03, which is 1.0291, and 1.0291 minus 1 is 0.0291, so the exact real return is 2.91 percent. The shortcut would have said 3 percent. Close enough for a porch conversation, though the exact figure is a touch smaller.

This works the other way too. When prices rise, the cost of what you will need later rises with them. A retirement that needs $40,000 a year in today's prices will need more dollars in thirty years to buy the same life. Thinking in real terms means you keep asking one plain question. What will this money actually do for me?

The numbers, and where to find yours

Your nominal rate is easy to find. It sits on your statement, or on the account page of your bank or plan provider. Look for the yield, the interest rate, or the annual return, whichever your provider shows.

The inflation figure takes one more step. The Bureau of Labor Statistics, part of the U.S. Department of Labor, publishes the Consumer Price Index, which tracks price changes for a typical basket of household goods and services. Its website shows the twelve month change, and that is the number most people mean when they say inflation. The Federal Reserve also sets a long run inflation goal, which it explains on its own site, and the current goal is the current figure, which the official source publishes each year. A goal is not a promise, so check the actual price index for what happened.

Some savers like Treasury inflation protected securities, which the U.S. Department of the Treasury issues and describes on TreasuryDirect. The principal on those rises with the Consumer Price Index. This guide only explains how they work. It does not suggest that anyone own them.

A worked example

Let me tell you about a woman named Maria, a school bus driver with a steady head and a small nest egg. She has $20,000 sitting in a savings account that pays 4 percent a year. In a year when inflation runs 3 percent, she looks at her balance and sees $20,000 times 1.04, which is $20,800. She feels good. She earned $800.

Now she thinks in real terms. Prices rose 3 percent, so what cost $20,000 a year ago now costs $20,000 times 1.03, which is $20,600. Her $20,800 can buy that same basket with $200 to spare. Her real gain is $200, not $800. As a percent, that is $200 divided by $20,600, or about 0.97 percent. The shortcut said 1 percent, and the exact method says 0.97 percent. Nice and close.

Now picture a different year. The account still pays 4 percent, but inflation jumps to 6 percent. Her balance again grows to $20,800. The old basket now costs $20,000 times 1.06, which is $21,200. Her $20,800 falls $400 short. Her balance rose, yet she can buy less than before. That is a negative real return, and it can sneak up on a person who only watches the statement.

Maria does not panic about this. She simply knows it. She keeps her emergency money where she can reach it, and she keeps in mind that a safe account may lose a little ground when prices climb fast.

Where it goes wrong

I have made this mistake myself, so I say it kindly. The first trouble is forgetting taxes. Interest and gains can be taxed, and the tax comes out of the nominal return. If Maria's 4 percent is taxed at 22 percent, she keeps 4 percent times 0.78, which is 3.12 percent after tax. Subtract 3 percent for inflation and her real after tax return is about 0.12 percent. That is a far thinner slice than the headline suggested. The IRS explains how interest income is taxed in its publications, and a tax professional can speak to an individual case.

The second trouble is using the wrong inflation number. Your own prices may not match the national average. A family that spends a lot on rent, tuition, or medical bills may feel inflation differently than the index shows. The index is a useful guide, but it is not a mirror of your kitchen table.

The third trouble is mixing past and future. Last year's inflation is known. Next year's is a guess. Any plan that depends on a single guess is fragile, so it helps to try a few different inflation rates and see how the answer shifts. Try 2 percent, then 3 percent, then 5 percent. Watch what happens. It is a humbling little exercise.

The fourth trouble is feeling bad about it. A negative real return does not mean you failed. It means the river is running fast. Knowing that lets you make calm choices.

Questions to answer before you leave this page

Do you know the nominal rate on each account you hold, and where on your statement it appears? Have you looked up the latest twelve month change in the Consumer Price Index on the Bureau of Labor Statistics website? If you subtract one from the other, is your real return above zero, near zero, or below it? Have you counted the tax on your earnings, so you see what you actually keep after tax? What would your balance buy in ten or twenty years if prices rise 2 percent a year, and what if they rise 4 percent? Which of your goals needs the money soon, and which can wait many years? And what is one small thing you will check on your accounts this week?