Remember to adjust for inflation in your financial plan

Inflation is not merely a statistic. It is a reality that every household needs to plan for.

These days I see many ads of financial/ investment products brimming with optimism, telling you how easy it is to become a crorepati. While I am definitely a supporter of optimism, I am against the fact that the optimism fails to take an important truth into account – ‘Inflation’. Inflation is the rise in price of day-to-day ‘stuff’…be it food, good or services. High inflation is a reality in a developing economy such as ours. It is also a slow killer by gradually but continuously reducing the value of money and in-turn the value of your savings. Every one of us must have heard our parents/grandparents cribbing about how something that used to cost only a few annas in the not so distant past costs few hundred rupees today. That’s inflation at work.

Can you believe that pulses have generated better returns than your fixed deposit over the last few years? That’s right - your fixed deposit returns didn’t even compensate for food price inflation. Meaning - money in a fixed deposit account that matures today would buy you less food than it did a few years back, when you initiated the FD. So despite the appearance of safe and sound returns of 8% p.a., the reality is that your money has earned negative return and reduced in “real value”!

Welcome to the world of “real returns”. Most investment products highlight what is called as “nominal returns” i.e. the rate at which your money will grow as a number. But just because your money is growing in “number” doesn’t mean that it is growing in “real value”. To know what is the growth in “real value” of your money, you need to adjust for inflation.

But how do you measure inflation? Well, the government seems to believe that the Wholesale Price Index (WPI), which computes the change in wholesale price of a set of commodities, is the right measure of inflation. But commodities are not the only “stuff” we consume and secondly we don’t buy them at wholesale prices. What’s more relevant to urban residents is another inflation index called the Consumer Price Index (CPI) for industrial workers, an index that is least publicized. The CPI calculates the change in consumer price of a set of goods and services such as food, clothing, fuel, housing, medical, transport, education etc. According to the most recent CPI data, the inflation is around 11.5% p.a.!! That’s how much more expensive things have become. In other words, that’s approximately the amount of value that your money has lost over the last one year, if you are an urban resident - a figure that is stark but nonetheless real.

Sample calculation for including inflation in your financial plan

Let’s say you have estimated that you need Rs 1 crore in today’s money value to retire, 20 years from now. Let’s assume that for this purpose you plan to invest fixed amount every month in a balanced equity mutual fund with a long-term track record. Being a conservative mutual fund scheme, you expect it to deliver approx 15% p.a. over the next 20 years, in line with the long-term average of stock market returns. How much money do you need to save and invest every month to attain your goal? Keeping inflation aside, the amount of money that you need to save works out to be very pleasant - just Rs 6700 per month! I am sure you are surprised at how low the number is.

But wait till you fast forward twenty years from now, and you will be in for a rude shock. Although you may have 1 crore in savings, you’ll realize that it’s no longer enough compared to the much higher cost of living prevalent then, thanks to inflation over the twenty year period. In fact if the amount of inflation over the next twenty years is going to be similar to what has happened over the last twenty years, you can reasonably expect around 6% annual CPI inflation. This would mean that twenty years from now your Rs 1 crore would be only as good as having Rs 31 lakhs today! i.e the value of money would have shrunk 3.2 times. If you don’t think Rs 31 lks is sufficient for you to retire today, Rs 1 crore will not be sufficient for you to retire after 20 yrs. Here’s how you can calculate the “real value” of future money:

Real value (in today’s money value) of Rs X, which will be available Y years from now =
X / (1+ annual inflation)^Y

Real value (in today’s money value) of Rs 1 crore, which will be available 20 years from now = 1 crore/ (1+6%)^20 = 1 crore/ 3.2 = 31 lks = shrinkage of 3.2 times

So, if your objective is to have Rs 1 crore in today’s money value, 20 years from now, you need to aim for total savings of Rs 3.2 crores and not just Rs 1 crore (to accommodate for shrinkage in money value by 3.2 times as a result of inflation). This means you need to invest approximately Rs 21,440 every month and not just Rs 6700 per month!! Do you see the difference of adjusting for inflation?

Ideally, you need to incorporate inflation in calculating how much you need to save for all the major financial commitments that you foresee in the near future – be it kids’ education, college, marriage etc. The only way to beat inflation is to prepare for it, well ahead. It’s therefore imperative that we adjust for inflation in setting our financial goals and planning for the same. Not accommodating for inflation leads to chronic under-saving - the impact of which is usually realized only when it’s time to use the savings.