Two Ways to Say the Same Thing
A pension pot of €600,000 at retirement in 25 years. Sounds substantial.
At 2.5% average inflation, that's worth about €324,000 in today's money — a little over half. At 3.5%, it's around €254,000.
Neither figure is more correct than the other. They're answering different questions. The €600,000 is a nominal amount: the number that will appear on the statement. The €324,000 is a real amount: what that money will buy relative to today.
Almost every long-horizon financial projection you'll encounter is quoted in nominal terms, and almost every decision you make with it should be reasoned about in real terms. Mixing the two is one of the most common sources of financial miscalculation, and it's entirely avoidable.
The Conversion
Going from nominal to real is one line:
real value = nominal value / (1 + inflation)^years
Or forward, from today's money to a future nominal amount:
nominal value = real value × (1 + inflation)^years
The Inflation Calculator handles this directly:
- Enter the amount.
- Enter the inflation rate.
- Enter the number of years.
- Read the adjusted value.
The rule of thumb worth memorising: at 3% inflation, purchasing power halves in about 24 years. That's the Rule of 72 applied to inflation rather than growth — 72 divided by 3. At 2% it's 36 years; at 5%, about 14.
The Fisher Relationship
When both a return and an inflation rate are involved, the correction isn't subtraction.
The approximation everyone uses:
real return ≈ nominal return − inflation
7% return minus 3% inflation gives 4%. Close enough for a quick estimate.
The exact relationship:
(1 + real) = (1 + nominal) / (1 + inflation)
Working it through: 1.07 / 1.03 = 1.0388, so 3.88%, not 4%.
The gap is small at low rates and grows as rates rise. At 20% nominal and 15% inflation, subtraction gives 5% while the exact calculation gives 4.35%. For long horizons or high-inflation environments, use the exact form.
Why this matters over decades
Compound the difference. €100,000 over 30 years:
- At 4.00% real: about €324,000
- At 3.88% real: about €313,000
An 0.12 percentage point difference in the assumption produces an €11,000 gap. Small errors in the rate compound just as returns do.
Real Terms Solves the Comparison Problem
Here's the practical case for working in real terms throughout.
Comparing across time. A salary of £28,000 in 2005 and £42,000 today aren't directly comparable. Deflate both to a common year and you find out whether that's a raise.
Comparing projections with different horizons. A plan projecting €400,000 in 15 years and one projecting €700,000 in 30 years can't be ranked by the nominal numbers alone.
Setting savings targets. "I want €40,000 a year in retirement" is a real-terms goal. Converting it to a nominal target requires an inflation assumption — and the nominal figure will look alarmingly large.
Evaluating a guaranteed return. A fixed deposit paying a guaranteed 3% is guaranteed only in nominal terms. If inflation runs at 4%, the real return is negative and the guarantee doesn't help.
The clean approach: do all your planning in today's money, using real rates of return. Then the numbers stay interpretable, and you never have to mentally deflate a projection.
The Cases Where Nominal Is What Matters
Real terms isn't always the right frame. Some obligations are fixed in nominal money, which changes the calculation entirely.
Fixed-rate debt. A mortgage with a fixed payment of €1,400 a month is €1,400 forever, regardless of inflation. In real terms that payment shrinks every year. Inflation is genuinely good for people holding long-term fixed-rate debt — the debt is eroded while the asset it financed typically isn't.
This is the classic asymmetry: inflation transfers value from lenders to borrowers when rates are fixed.
Nominal-denominated savings. Cash under the mattress, a fixed-rate bond held to maturity, a non-indexed pension. All lose real value at exactly the inflation rate.
Tax thresholds. Where income tax bands, capital gains allowances or inheritance thresholds aren't indexed to inflation, nominal income growth pushes people into higher brackets without any increase in real income. This is fiscal drag, and it's a significant and often-overlooked cost of inflation.
Capital gains tax. Most systems tax nominal gains, not real ones. Buy an asset for €50,000, sell it for €70,000 after ten years of 3% inflation, and your real gain is close to zero — but you may be taxed on the full €20,000.
Building an Assumption You Can Defend
Any long-term projection needs an inflation number, and the choice matters more than people expect.
Central bank targets are a reasonable anchor. The ECB, Bank of England and Federal Reserve all target around 2%. Over long horizons, targets are a defensible starting assumption.
Recent experience is a poor guide. Extrapolating from a high-inflation year or a low-inflation decade both produce bad long-run estimates. Inflation is mean-reverting over long periods and volatile over short ones.
Your personal rate differs from headline CPI. The basket is a national average. If a large share of your spending is on categories rising faster than average, your effective rate is higher.
Run scenarios rather than a single figure. Model at 2%, 3% and 4% and see how much the conclusion changes. If your plan works at all three, the assumption isn't load-bearing. If it only works at 2%, you've found a fragility worth knowing about.
That last practice is the single most useful discipline here. A projection quoted to the euro with one inflation assumption implies a precision that doesn't exist.
Worked Example
Suppose you want the equivalent of €35,000 a year in retirement, starting in 20 years, in today's purchasing power.
Step 1 — find the nominal amount you'll need. At 2.5% inflation:
35,000 × 1.025^20 = €57,350
So you need roughly €57,000 a year in nominal terms at the start of retirement.
Step 2 — decide whether to plan in real or nominal. Planning in nominal means every subsequent number is inflated and hard to interpret. Planning in real means using a real rate of return and keeping €35,000 as the target throughout. The second is easier to reason about and easier to sanity-check.
Step 3 — remember the target keeps rising during retirement. €57,000 in year one is €93,000 in year twenty at the same inflation rate. A withdrawal plan with a fixed nominal amount loses purchasing power throughout retirement. Withdrawal strategies that adjust with inflation exist for this reason.
Common Mistakes
Subtracting inflation from returns. Use the Fisher relationship for anything long-term or high-rate.
Mixing real and nominal in one calculation. Applying a nominal return to a real target, or vice versa, produces a number that means nothing.
Forgetting inflation continues after retirement. A twenty-year retirement faces as much cumulative inflation as the twenty years before it.
Assuming index-linking covers everything. Some pensions and benefits are capped at a maximum annual increase, which means they fall behind in high-inflation years and don't catch up.
Treating a guaranteed nominal return as safe. Capital protection is not purchasing power protection.
Applying today's inflation rate to a thirty-year projection. Recent rates are the worst available predictor of long-run averages.
FAQ
What's the difference between real and nominal? Nominal is the face value of money. Real is that value adjusted for inflation, expressed in the purchasing power of a chosen base year.
Why isn't real return just nominal minus inflation? Because it's a ratio, not a difference. The approximation is fine at low rates and increasingly wrong as rates rise.
What inflation rate should I use for planning? Central bank targets around 2% are a defensible anchor, but run scenarios at a range of rates rather than committing to one.
Does inflation help borrowers? For fixed-rate debt, yes — the real value of the payments falls over time. For variable-rate debt, rates usually rise with inflation, which removes the benefit.
What is fiscal drag? Nominal income growth pushing taxpayers into higher brackets when thresholds aren't indexed to inflation, raising effective tax rates without any policy change.
Should I plan in today's money or future money? Today's money, using real rates of return. The figures stay interpretable and you avoid nominal amounts that look impressive but aren't.
The Takeaway
Nominal figures answer "what number will appear on the statement." Real figures answer "what will it buy." Financial planning is almost always a question of the second kind, and the discipline of working in today's money throughout — with a real rate of return and a scenario range rather than a single inflation assumption — removes most of the errors in this area.
Adjust any amount for inflation free with the Inflation Calculator at sadiqbd.com — no sign-up, instant results. This article is general information, not financial advice.
