If your investment earns a 5% annual return, does that mean your wealth has actually grown by 5%?
Looking only at the balance in your bank or investment account, it may seem that you earned a 5% return. However, if prices rose by 3% during the same period, your purchasing power did not increase by the full 5%.
When managing retirement savings, you need to consider not only the nominal return shown in your account but also the real return after inflation. This is especially important after retirement, when earned income usually declines and living expenses must be withdrawn from accumulated assets. Without accounting for changes in purchasing power, a long-term retirement plan may be more optimistic than reality.
What Is a Nominal Return?
A nominal return is the return shown in your account before accounting for inflation, taxes, fees, and other costs.
For example, if you invest 100 million won and the balance grows to 105 million won after one year, the nominal return is 5%.
The nominal return can be calculated as follows.
Nominal Return = Investment Gain ÷ Initial Investment × 100
A nominal return provides a simple way to review investment performance, but it does not show how much your purchasing power has actually increased.
What Is a Real Return?
A real return is the investment return after accounting for the loss of purchasing power caused by inflation.
Investor.gov, a website operated by the U.S. Securities and Exchange Commission, describes real return as the return earned after accounting for taxes and inflation.
For retirement planning, what matters most is not simply how much the account balance has increased, but how much of your actual living expenses that money can cover.
A Simple Way to Estimate Real Return
You can estimate the real return using the following simple formula.
Real Return ≈ Nominal Return − Inflation Rate
If the nominal return is 5% and inflation is 3%, the estimated real return is approximately 2%.
5% − 3% = 2%
This method is quick and easy to understand, but it is only an approximation. The difference between the estimate and the exact result may become larger when investment returns and inflation rates are higher.
How to Calculate the Exact Real Return
The exact real return can be calculated using the following formula.
Real Return = (1 + Nominal Return) ÷ (1 + Inflation Rate) − 1
With a 5% nominal return and a 3% inflation rate, the calculation is as follows.
(1.05 ÷ 1.03) − 1 = Approximately 0.0194
Therefore, the exact real return is approximately 1.94%.
The simplified calculation produces a 2% return, while the exact formula produces approximately 1.94%. When estimating retirement savings over a long period, it is better to use the exact formula.
What Does This Mean for a 100 Million Won Investment?
If 100 million won earns a 5% annual return, the account balance will grow to 105 million won after one year.
However, if prices rose by 3% during the same period, the purchasing power of that 105 million won can be calculated as follows.
105 Million Won ÷ 1.03 = Approximately 101.94 Million Won
Although the account balance increased by 5 million won, its inflation-adjusted purchasing power increased by only about 1.94 million won.
If you ignore this difference, your projected retirement savings may appear much larger than their actual future purchasing power.
Taxes and Fees Must Also Be Considered
When calculating your actual investment return, you need to consider not only inflation but also taxes and investment fees.
For example, even if an investment has a nominal return of 5%, you should use 4.2% in the real-return calculation if the net return after fees and taxes is only 4.2%.
If the net return is 4.2% and inflation is 3%, the exact real return is calculated as follows.
(1.042 ÷ 1.03) − 1 = Approximately 1.17%
Even fees that appear small can make a significant difference when compounded over many years. When comparing financial products, do not look only at the advertised return. Check the actual return after taxes and fees.
Why Real Return Matters in Retirement Planning
1. It Helps You Set a More Realistic Retirement Goal
To estimate how much retirement savings you will need based on your current living expenses, you must account for how inflation changes purchasing power.
how inflation affects retirement savingsHow inflation affects retirement savings and calculating real returns can help you estimate future living expenses and retirement goals more realistically.
2. It Prevents Overly Optimistic Withdrawal Plans
the 4% retirement withdrawal rule or a similar strategy, you still need to consider both investment returns and inflation.
If you assume an unrealistically high nominal return, you may believe that your assets are growing sufficiently even while their purchasing power is declining.
3. It Allows You to Compare Different Financial Products on the Same Basis
Savings accounts, bonds, mutual funds, and ETFs have different expected returns and levels of risk.
When comparing financial products based only on nominal returns, the product with the highest return may automatically appear to be the best choice. However, calculating real returns after taxes, fees, and inflation allows you to compare products based on actual purchasing power.
4. It Helps You Evaluate Your Current Financial Position More Accurately
After learning how to calculate your current net worth and reviewing your assets and liabilities, the next step is to assess how quickly your holdings are growing in real terms.
Even if your net worth has increased, your real purchasing power may have declined if its growth rate was lower than inflation.
5 Steps for Reviewing Your Retirement Returns
- Check the nominal return on your investment account.
- Calculate the net return after taxes and fees.
- Check the inflation rate for the same period.
- Apply the figures to the exact real-return formula.
- Compare your assumptions with the actual results every year.
When creating a long-term plan, avoid relying on a single assumed rate of return. Using conservative, baseline, and optimistic scenarios can help you prepare for market fluctuations and higher-than-expected inflation.
Does a Negative Real Return Mean You Lost Money?
Even if your account balance increases, the real return can be negative when the investment return is lower than the inflation rate.
For example, if a savings account pays 2% while inflation is 3%, the balance will increase, but the amount of goods and services that money can buy will decrease.
This does not mean that the principal disappeared from the account. It means that the purchasing power of the money declined.
ConclusionConclusion
A nominal return shows how much the account balance has increased, while a real return shows how much the purchasing power of that money has actually grown.
When calculating retirement savings, it is more important to use a realistic return after inflation, taxes, and fees than to assume a high investment return.
A projected return is an assumption used for planning, not a guarantee of future results. Compare your expected and actual returns regularly, and adjust both your living expenses and withdrawal plan when necessary.
This article is for general financial information only and does not guarantee individual investment returns or the performance of any financial product.
References
Bank of Korea, Understanding Interest Rates
Investor.gov, Real Return
Investor.gov, How Fees and Expenses Affect Your Investment Portfolio