Inflation and real returns
A balance that grows 7% a year does not buy 7% more. How to turn a nominal return into a real one, and what inflation does to money over ten and thirty years.
Nominal and real
A return can be measured in two ways. The nominal return is how much the amount of money grows. The real return is how much more that money can buy. The gap between them is inflation.
The calculator works in nominal terms, like almost every figure a bank or fund quotes. That is not wrong, but a balance thirty years from now will be spent at thirty-years-from-now prices, and a large number can buy a lot less than it looks.
Turning one into the other
The exact conversion divides one growth factor by the other:
real return = (1 + nominal return) ÷ (1 + inflation) − 1
At a 7% nominal return and 2% inflation, that gives 1.07 ÷ 1.02 − 1, a real return of 4.90% a year. At 3% inflation it gives 3.88%.
The quick version is to subtract: 7% − 2% = 5%. At low rates the shortcut is close enough for most purposes. It drifts further from the exact figure as rates rise, and it always slightly overstates the real return.
What it looks like over time
Here is £5,000 growing at 7% a year, compounded annually, shown both as the amount on the statement and as what that amount would buy in today's prices.
| After | Balance | In today's money, 2% inflation | In today's money, 3% inflation |
|---|---|---|---|
| 10 years | £9,836 | £8,069 | £7,319 |
| 30 years | £38,061 | £21,013 | £15,681 |
After thirty years at 2% inflation, the balance buys about 55% of what its face value suggests. At 3%, about 41%. The money still grew in real terms — just by much less than the headline number.
Money that is not invested
Inflation works on money that earns nothing, too. £5,000 kept aside for ten years with no interest buys what £4,102 buys today if inflation runs at 2%, or £3,720 at 3%.
The same arithmetic as the rule of 72 applies in reverse: at 2% inflation, money loses half its buying power in about 35 years. At 3%, in about 23.
Using the calculator in real terms
To see results in today's money, enter the real return instead of the nominal one — 4.9% rather than 7%, if you expect 2% inflation. Every figure the calculator shows is then roughly in today's prices, which is often the more useful way to think about a goal decades away.
Regular contributions complicate this slightly, because in practice people tend to raise them as prices rise. Using the real return assumes your contributions keep their buying power, which is a reasonable simplification.
Fees and taxes come off the return in much the same way inflation does. See how fees compound for what a yearly fee does over the same kind of time span.
Inflation is never steady, and no return is either. These examples show how the two interact, not what either will be, and nothing here is financial advice.