FundsIndia Explains: Role of Inflation in Financial Planning

If you have ever spoken to a financial advisor, they might have asked you about your financial goals. Thinking of your investments in terms of goals requires you to estimate the amount of money you will need at a future date. People often take current costs and use that as an estimate of their requirements. For instance, if a person is saving for his child’s education, and an engineering degree currently costs  Rs. 10 Lakh, the investor might state that he/she would like to save an arbitrary amount of say Rs 12-15 Lakh for their child who is now 3 years old.

How much impact does inflation have

This kind of estimation is unrealistic. Estimates should consider the expected inflation rates for the entire duration of the goal. For instance, if a goal is 15 years away, an inflation rate of 7% will lead to prices multiplying  2.8 times. This means that a course which costs Rs. 10 Lakhs today will cost Rs. 28 Lakhs 15 years from now.

The effect is more pronounced while estimating monthly requirements well into the future. At times I have been asked, “how can I earn Rs. 1 Lakh every month after I retire.” The assumption here is that the person needs Rs. 1 Lakh per month at the time of retirement. However, what is not being considered is that Rs. 1 Lakh per month is not going to be enough forever.

Think of it this way. How quickly does the cost of rice rise? According to data released by Ministry of Statistics and Program Implementation (MOSPI), the same quantity of rice which would have cost you Rs. 100 in January 2014 (2014 was taken as it comes with a name base for inflation), would cost you Rs. 114 in October 2017. This is an increase of 3.6% per year.

Medical costs rise faster than food prices. According to the same MOSPI data, during the period of January 2014 to October 2017, hospital and nursing home charges grew by 6.8% per year whereas doctor’s/surgeon’s fees grew by 7.8% per year.

Consider a 50-year old man whose current monthly expense is Rs. 50,000. He wants to retire at the age of 60. Even if we were to assume a modest rate of inflation of 4%, he would need Rs. 74,000 per month at the time of retirement, Rs. 1,10,000 per month when he is 70-years old and Rs. 1,62,000 per month when he is 80-years old. And this is considering no change in lifestyle. An improvement in living standards will increase the required amount and a higher need for medical attention in old age will definitely inflate this further.

This is what makes accounting for inflation so important when you are calculating your goal amount. Ignore inflation and you will fall short of your target. For a realistic estimation of your target amount, you need to consider inflation at a reasonable rate.

Historically, India has been a country with a relatively high rate of inflation, going into double digits. It’s only recently that inflation rates have come down below 4%. So next time you are estimating your monetary needs in the future, don’t forget to take inflation into account.

How to beat inflation

People in India traditionally prefer FD and PPF for long term investments. However, FDs have time and again failed to beat inflation on a post-tax basis. Here is a comparison of post-tax returns from 3-year fixed deposits and inflation over the period at various points:

Hence it is important to invest in instruments that provide returns higher than the prevailing inflation. Equities, as an asset class, have consistently beaten inflation in India. Even debt funds have mostly managed provide inflation-beating returns on a post-tax basis.

During the period from January 2011 to October 2017, a monthly SIP in a large cap equity fund would have given you a return of 15.35% per year. At the same time, an SIP in income funds would have given you a return of 8.55% per year.

Here are different scenarios showing how much an SIP in a weighted portfolio of debt and equity funds would have returned over January 2011 to October 2017:

The returns shown above are the category average returns considering large-cap equity funds for equity and income funds for debt, as classified by Fundsindia. Real returns represent the return on your portfolio less inflation. You can achieve higher returns with good fund selection.

A correct estimation of your target amount, good mix of asset classes, along  with good choice of funds will help you reach your goals without hitches.