TL;DR
Real returns = nominal returns minus inflation. Over long horizons, real returns are what fund your purchasing power. US equity real CAGR is ~6.7% since 1871; nominal CAGR is ~9.4%.
The mistake that costs retirees their lifestyle
If you plan in nominal terms, you systematically over-estimate your wealth.
Example: you retire with £1,000,000, expect 6% nominal returns, and plan £40,000 of annual spending. In year 1 you get your 6% — portfolio is £960,000 after withdrawal. Looks fine.
But inflation that year was 3%. Your real portfolio is £960,000 / 1.03 = £932,000 of last year's pounds. Your £40,000 next year needs to grow to £41,200 just to buy the same things. The portfolio has to grow faster than inflation just to maintain purchasing power.
Over 30 years at 3% inflation, your £40,000/year lifestyle costs roughly £97,000/year nominally by year 30. A plan that ignores this is a plan that runs out.
How real and nominal relate
The exact formula:
(1 + real) × (1 + inflation) = (1 + nominal)
For typical values (3% inflation, 6% real), this gives a nominal return of about 9.2%. The Fisher approximation (real ≈ nominal − inflation) is close enough for most planning work.
The interesting cases:
- Nominal positive, real negative. 1973: stocks up nominally, down materially in real terms. Many investors didn't realise their wealth was eroding.
- Nominal negative, real positive. 2009: stocks down nominally, but deflation in the second half meant some segments held real value.
- Both nominal and real high. 1995–1999: roaring nominal returns with low inflation. Doesn't happen often.
Why FIRE plans must use real returns
Three reasons:
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Your spending is real. Groceries, rent, transport — these track inflation, not asset prices. You need real purchasing power, not nominal pounds.
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Long horizons amplify the difference. Over 30 years at 3% inflation, £1 of nominal value loses 59% of its real worth. Confusing real and nominal halfway through a 30-year plan compounds into a major error.
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Historical data only makes sense in real terms. The 1970s 10-year nominal CAGR was about 6%. Sounds OK. The real CAGR was −1%. Catastrophic. Anyone planning off the nominal number got fooled.
What about deflation?
Deflation flips the sign — your nominal portfolio holds the same value, but the real value rises. During the 1930s deflation, retirees on a fixed nominal pension saw their real income rise. But equity prices crashed in nominal terms too, so most portfolios still lost real wealth.
Modern monetary policy makes sustained deflation unlikely. The bigger risk is the opposite — chronic mild inflation that erodes purchasing power without anyone noticing.
How to think about it operationally
Three habits:
- State all projections in today's pounds. Software like our simulator shows everything in real terms by default.
- Track your savings rate in real terms. A £1,000/month savings rate that doesn't rise with inflation falls in real value every year.
- Calibrate withdrawals to inflation, not portfolio value. The 4% rule's "increase withdrawals by inflation each year" rule is what makes it actually meaningful for purchasing power.
Plan in real, report in real, think in real. The nominal numbers are only useful for HMRC.
Frequently asked questions
- What inflation measure should I use?
- CPI for the US, CPI for the UK (not RPI — RPI runs higher and is being phased out). Both track consumer goods baskets but with slightly different methodologies.
- Are bond yields quoted in real or nominal?
- Both exist. Conventional gilts/Treasuries quote nominal yields; inflation-linked gilts and TIPS quote real yields. The difference between the two is the market's inflation expectation.
- How much inflation should I assume going forward?
- 2% is the long-run Bank of England and Fed target. 3% is the historical average since 1913. Plan around 2.5–3% for safety.
Stress-test your own FIRE plan
FIRE Wealth OS runs your savings rate and expenses against every historical market starting point since 1871. Free to use, no card required.