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23 October, 2018 10:54 IST
Financial Planning
   
Impact of Inflation on Financial Planning
Source: IRIS (13-AUG-18)

Any conversation with the previous generation, irrespective of the generation you belong to, brings you to a common refrain that how the life has completely changed from what it was in their youth. Multiple examples of change always end with ruing the fact that money does not have the value it used to have - ab to paise ki keemat hi nahi rah gayi. At the root of this conversation is nothing but simple concept of inflation, a number announced by the government every month and even the common man is aware of it. The inflation based on Consumer Price Index (CPI) increased by 5.07 per cent in January 2018 in India.

Inflation is one such economic term which everyone of us understands and experience it in our day to day life. However, when planning for our future needs, especially the life stage needs which are many years away, we tend to ignore the impact of inflation. Consumers tend to think in nominal rather than real terms. For a 23-year-old who earns one lakh rupees a month, a retirement corpus of one crore rupees looks enormous and many a times even more than he requires. Just 22 years down the line, with an average increment of 10%, the same person now 45-year-old, would be earning one crore rupees a year. Is a rupees one crore retirement corpus enough? Certainly not.

Impact of inflation on financial planning is one of the most underestimated follies. So let us see what is inflation? Inflation is general increase in prices and fall in purchasing power of money. The Government of India calculates inflation basis CPI that measures the weighted average of prices of a basket of products commonly used by an average household.

So, why does inflation erode the value of your investment? Because the ability of money to purchase keep depreciating with inflation and money is important only because it has the purchasing power to satisfy your needs. If your needs have not changed, in the same amount of money you spend today, some of your needs will remain unfulfilled at a future date. Because of inflation, the real value of your savings keep reducing. That is why an investment advisor always talk about how the investment he is suggesting will help beat inflation.

So how do you beat the inflation?

Do not undermine the power of inflation: The first step in this direction would be to stop undermining the power of inflation on your financial portfolio. It is important to take inflation in account while making financial plans to ensure that you do not fall short of funds at a later stage in life. There is a possibility that your corpus is growing at a satisfactory level as per your estimates, but it is important to do the inflation test every few years as the definition of 'satisfactory' keeps changing with the rise or fall in inflation. It is also a good practice to compare the growth in your corpus with that of your monthly expenditure.

In addition, don't assume inflation to be the same for all kind of expenses. Education inflation, especially in case of higher education in India, has been more than 10 per cent over the past decade as compared to inflation measured in terms of CPI been around 7 per cent. Similar is the case of medical inflation. Hence, for each of your need review the impact of inflation separately.

Focus on real return: Interest rates can normally be expressed in two ways - real and nominal rates. Nominal rates are the coupon rate which is mentioned on the FD/Bond which you have bought. Whereas, the real rate is inflation and income tax adjusted rate. If the interest rate is lower than inflation rate, then instead of adding value to your investment, you will see the real value or the purchasing power of your investment depreciating. Hence, it is important to know the Consumer Price Index bases inflation rate and the income tax rate which will be applicable for you before taking an investment call. 

Save more every year: A substantial corpus is a result of regular savings made over a period of a time which is then prudently invested. However, the regular savings that you make right now, might not be enough to take care of your future expenses unless it grows in line with your life stage needs. In order to ensure a balance between savings and expenses, keep increasing the share of your savings vs your expenses. This means every year when you get an increment or income increases, expand your savings first and then think of making changes to your lifestyle that will increase your expenses.

Diversify your investments: In order to make your savings grow faster than inflation, it is important to choose your investment options wisely. Don't put all your funds at risk by investing all your savings in any one option. By carefully distributing your funds in different investment instruments, you can decrease your risks and still expect good returns. If one of your investment is not able to beat inflation due to cyclical movements, some others will be and thus help you remain ahead of inflation.

Don't shun equity: Looking at the return on investment trends over the long-term, it has been observed that equity gives the best return. Of course if your investment horizon is short-term, equity may prove to be a riskier investment. Start investing in equity when you are young either through ULIPs or mutual funds. Graduate to direct investment in equity shares, when you understand the market dynamics well and have the ability to assess future growth potential of a company. However, if you are young and your need is still away by more than five years, invest in equity to beat inflation and create a healthy investment corpus.

Impact of inflation on retirement planning: The biggest fallout of inflation is its impact on financial planning for those so call golden years of retired life. Those golden years could well turn into the years of penury and dependence, if we do not make your retirement planning inflation proof. Most of the time while planning for retired years, we make the mistake of assuming expenses to be constant throughout those 20-30 years of retired life. With increasing life expectancy, there is a possibility that the retirement years maybe as long as the earning years. To avoid lack of funds to sustain lifestyle in later years of retirement, one should opt for increasing annuity option which will take care of inflation.

Financial security comes with better financial planning which must be reviewed at regular intervals. The sooner you start saving for the future, the better it is. However, it will truly be effective when you keep your financial planning aligned with changing inflation. If compounding is considered to be the eighth wonder, inflation is just the other side of that wonder.  

(Authored by  Prashant Tripathy-Senior Director and Chief Financial Officer, Max Life Insurance)

Disclaimer: IRIS has taken due care and caution in compilation of data for its web site. Information has been obtained by IRIS from sources which it considers reliable. However, IRIS does not guarantee the accuracy, adequacy or completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such information. IRIS especially states that it has no financial liability whatsoever to any user on account of the use of information provided on its website.


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