- April 10, 2017
- Category: Financial Planning, Investments
“Inflation is when you pay fifteen dollars for the ten-dollar hair cut you used to get for five dollars when you had hair.”
This is a very popular saying by Saw Ewing which describes inflation in simple words. If you ask a layman about inflation, he will quickly correlate the term with the rise in veggies & grocery prices. It is common knowledge that inflation affects the household budget.
But most people do not understand or fathom the future impact of inflation. The concept of compound interest on fixed deposits is well understood by many, i.e., interest earning interest. But people do not realise that inflation has a compounding impact too every year, i.e., prices rise on top of the preceding year’s inflation. So, for e.g., suppose you open a Rs.1 lakh bank fixed deposit earning 7.5% p.a. for a period of 10 years. Your money doubles in 10 years to Rs.2 lakh and you feel happy about it. But during this period, inflation has also risen at the same pace of 7.5% p.a., may be more. So, effectively, you have not become richer. Because the things that you could buy with Rs.1 lakh 10 years ago, now costs Rs.2 lakh, maybe more. This is how inflation affects your spending power.
Inflation not only has the ability to reduce your purchasing power but also affect your investment returns in the long run. More importantly, it can disrupt your financial goals. For instance, inflation in child’s education can pinch you real hard which on an average rise by about 10% p.a. Suppose you would require Rs.3 lakh (current cost) to pay for your child’s college fees after 5 years. For this purpose, you open a fixed deposit of Rs.3 lakh yielding 7.5% p.a. At the end of 5 years, your investment would have grown to approximately Rs.4.3 lakh. However, college fees would have risen by 10 % p.a. during this period, taking the target amount to Rs.4.8 lakh. This would create a shortfall of Rs.50,000.
The eroding impact of inflation on investment returns is felt much more in the long term for essential goals like retirement. When we sit with clients to do the retirement math, we explain to them how expenses would look like due to inflation in the long term. For instance, an average household budget of Rs.30,000 at current cost will grow to Rs.19 lakh in 25 years, assuming an inflation of 7% p.a. For this purpose, one needs to have about Rs.4 crore in retirement fund to last for another 30 years.
Clients find such extrapolations hard to believe.
If inflation is not taken into account while planning for future expenses, the monetary requirement keeps getting higher and higher to maintain the same standard of living as years pass by and eventually create a serious shortfall in the retirement fund.
So, the danger of outliving retirement savings is real in the future. Refer to the consumer price index (CPI) inflation chart.
Looking at this chart, one needs to realise that inflation is here to stay in a developing economy like India.
Inflation poses a real threat to financial goals and one cannot control the fact that the cost of goods and services will keep going up. What needs to be done then is to invest in assets that have the potential to grow more than the rate of inflation to increase the real purchasing power in the long term. Time and again, it is proved that equities is the best asset class which has consistently beaten inflation in the long run. So, it is imperative to have some exposure to equity in your portfolio so that the total returns average above inflation in the long term.
An expert financial advisor can help you do the math in planning for all your future financial goals taking into account inflation. Considering an appropriate inflation number, an advisor can help you estimate the future cost of your financial goals and accordingly determine your asset allocation.
To conclude, you as a future retiree who will probably live longer and without pension income needs to understand that the retirement target corpus is not an exaggeration. Referring to your parents’ old budget records of their frugal days will serve as a good reminder. Look to the past to understand the present and prepare for the future!