Inflation is quite often called the thief of purchasing power. Why is that so? That is because inflation measures the rate of price rise per annum. If the price of food, fuel, clothing and housing are growing very fast each year then it means that your income will be able to buy less of the same thing. Alternatively, your income will have to grow faster than inflation so that at least your standard living can be maintained. But how does inflation impact your financial planning?
Financial planning entails laying out your long-term financial goals and then creating a plan to move towards these goals. Inflation hits your financial plan on multiple counts. It impacts your future cost of living; it has an effect on the real returns that you will earn on your investments and it will also have an impact on the way you plan for your future goals. Let us look at four such effects.
1. Effect on the value of your future goals
The way you go about financial planning is that you first lay out your dreams and then work backward to see how you need to invest for the same. However, when it comes to your retirement planning, you first need to project your monthly maintenance costs. The normal method of doing it is that you take your current costs and inflate the number into the future with appropriate assumptions. Then that number gets adjusted for a shift in standard of living. Have you ever wondered how much would your requirement change if inflation shifts? Check out the table below.
|Rate of Inflation||4%||5%||6%||7%|
|Years to Retirement||25||25||25||25|
|Monthly Funds required||2,66,584||3,38,635||4,29,187||5,42,743|
What the above table shows is that with every 1% upward shifts in inflation, the monthly expense goes up by nearly 27%. Effectively, if the inflation goes up by 3%, then the monthly requirements will more than double. That means your corpus has to be proportionately higher and your regular SIPs should also be proportionately higher.
2. Future inflows are going to be worth a lot less today
This is a contra approach to looking at financial planning. In the first point, we looked at the future value of today’s money. At this point, we are looking at the present value of future money. Let us say you are going to receive fixed corpus of funds in the future. Shifts in inflation will make a difference to how much these future inflows are worth today. Check out the table below:
|Getting After X Years||1||2||3||4||5|
|Corpus to be received||5,00,000||5,00,000||5,00,000||5,00,000||5,00,000|
|Rate of Inflation||4%||4%||4%||4%||4%|
|Rate of Inflation||6%||6%||6%||6%||6%|
In the above table, we have simulated a cross-section of possibilities. Let us consider a 3-year scenario. At 4% inflation, a corpus of Rs.5 lakh that you will receive after 3 years will be worth Rs.4.44 lakhs today but if inflation goes up to 6% then the same corpus will be worth only Rs.4.19 lakhs today. Let us now look at a 5 year period. At 4% inflation, a corpus of Rs.5 lakh that you will receive after 5 years will be worth Rs.4.10 lakhs today but if inflation goes up to 6% then the same corpus will be worth only Rs.3.73 lakhs today. That is how inflation impacts your future corpus value.
3. It eats away a part of your returns
In financial planning, the real returns matter a lot more than the nominal returns because that is what determines the purchasing power. For example, if a bank FD is giving returns of 8% when inflation is 5%, then your real return is 3%. However, if bank FDs are giving 9% returns with inflation at 7% then your real returns are just 2%. It is not just the nominal returns on your investment that matters. What also matters is how much of real returns you are earning. That gets impacted by the rate of inflation. That is how inflation tends to impact your returns on investment.
4. Review of your insurance requirements
Your life policy is normally your back-up to take care of your family in the event of any exigency. How is the life policy corpus determined? For example, if you expect that your family will need a monthly income of Rs.1 lakh to run the house, then you can take a policy of Rs.3 crore so that even if the corpus is invested in a safe money market fund giving 4% real returns, that can still cover the needs of your family. However, if inflation was to go up, then the insurance corpus will have to be higher.
What does all this add up to?
When inflation goes up, your eventual corpus requirement will go up. Then you have two choices. You can either reduce your goal amounts; which is quite difficult or you can increase your monthly SIP savings. When inflation goes up your future goals have to be met with higher savings or higher risk investments. It is a choice between the devil and the deep sea.
The article has been sourced from Angel Broking. Views expressed are their own