Definition
Real versus nominal discount rate is the distinction between a rate stated in real terms (return above inflation) and a rate stated in nominal terms (including inflation), applied so that projected cash flows and the rate used to discount them are on the same basis.
Why it matters
Retirement income planning necessarily involves multiple decades, over which inflation compounds substantially, so failing to keep cash flows and discount rates consistent produces misleading present-value results. The distinction is not conceptual sophistication but arithmetic discipline: a nominal payment stream discounted at a real rate, or a real payment stream discounted at a nominal rate, produces a figure with no clean interpretation.
How it works
A real rate reflects the return above inflation; a nominal rate includes the inflation component. The relationship between the two is approximately additive at low rates: a 3 percent real rate combined with 2 percent expected inflation is approximately a 5 percent nominal rate. More precisely, the two rates relate as one plus the nominal rate equals one plus the real rate times one plus inflation, so at 3 percent real and 2 percent inflation the exact nominal rate is 5.06 percent. Which convention to use is a matter of matching the discount rate to the cash flow basis: an inflation-adjusted lifetime income payment is discounted at a real rate; a fixed-nominal payment is discounted at a nominal rate. Actual purchasing power comparisons require using real rates on both sides, and this is the convention lifetime income analysis conventionally adopts because the individual's consumption need is in real terms.
In practice
For an individual evaluating a lifetime income arrangement, whether payments are stated in real or nominal terms is one of the first structural facts to identify. A fixed-nominal SPIA and a real-adjusted arrangement cannot be compared without translating them to a common basis, and the translation depends on an assumption about future inflation. A professional working through the comparison will typically state both the discount rate convention (real or nominal) and the inflation assumption being used. Individuals encountering income figures should ask which basis is being used; a 5,000-dollar monthly payment retains its purchasing power under a real arrangement and loses it steadily under a fixed-nominal arrangement.
Related terms
- Discount rate
- Present value
- Real interest rate
- Nominal interest rate
- Inflation risk
- Purchasing power risk
- Real versus nominal returns
- Inflation-adjusted income