Why Should You Consider Inflation in Planning Your Long Term Goals?

5paisa Research Team 5paisa Research Team 30th March 2022 - 12:51 pm

Inflation is the rate at which prices go up annually. But, why is it so important? Inflation matters because over time it erodes value. Let us look at inflation from a different perspective. If the annual inflation is 5% then a product of Rs.100 will cost Rs.105 after 1 year. If you were to receive Rs.100 after 1 year then its value will be Rs.95.24. In other words, the value of Rs.100 today is not the same as the value of Rs.100 after one year. But why is that so important to financial planning and long term goals.

Just as returns compound, inflation also compounds

Have you heard your father or grandfather nostalgically recollect how they could buy all the joys of the earth for Rs.10 and how the world changed into a more materialistic place? What they are effectively talking about is inflation. Inflation erodes the value of money over time and your income needs to growth at a rate that is faster than the rate of inflation.

As the above equation depicts, what matters is the real return that you earn post inflation; and this is more critical when you are looking at longer periods of time. Let us assume equity returns at 14% per annum and inflation at 5%.

Actual Returns	Amount	Real Returns	Amount
Investment Amount	Rs.1,00,000	Investment Amount	Rs.1,00,000
Yield on Investment	14%	Inflation Rate	5%
Nominal Returns	14%	Real Returns	9%
Holding Period	15 years	Holding Period	15 years
Corpus after 15 years	Rs.7,13,794	Corpus after 15 years	Rs.3,64,248
Nominal Wealth Ratio	7.14 times	Nominal Wealth Ratio	3.64 times

Interestingly, you may be celebrating that you have multiplied your wealth 7 times over in 15 years. But if you remove the impact of inflation then the wealth nearly halves. That is why factoring inflation is the key to getting a proper picture of your future wealth.

Knowing the future value of your expenses

Financial planning is never about the next 2-3 years but about the next 20 years. You want to use the power of compounding to make money work harder. Let us look at the role of inflation in knowing the future value of your retirement needs and your insurance needs.

Case 1: How much should you save for retirement? Your starting point will be your monthly expenses. Let us say, your monthly expenses for your family of four is currently Rs.90,000 per month. Now what is the amount you should plan for? If you are planning to retire after 20 years then you can inflate at 5% annually for the next 20 years. That gives you a monthly expense of nearly Rs.2,40,000 per month after 20 years. Of course, there could be shifts in standard of living but your expenses will also come down due to lesser number of dependents. This inflation adjusted spending should be your base case.

Case 2: How much life insurance you need to buy? Of course, we are talking about a pure risk cover. Since you are looking at a 20 year horizon, consider expenses after 10 years as the benchmark. After 10 years your family will require at least Rs.1,47,000 per month to maintain the same standard of living. Now how do you plan the size of your insurance cover? Check the table below.

Particulars	Amount
Current Monthly Expenses	Rs.90,000
Monthly expenses after 10 years at 5% inflation	Rs.147,000
Annual income needed after 10 years	Rs.17,64,000
Where will the insurance corpus be invested?	5% liquid funds
Insurance corpus to earn above income (Rs.17.64 lakhs / 0.05)	Rs.3.53 crore

You can use the inflation approach to determine that you require a life risk cover of Rs.3.53 crore to take care of regular income needs in your absence. In the event of any exigency, this would take care of family running expenses for the next 10-15 years.

Need to tweak your plan with inflation shifts

This is an aspect of inflation, most of us tend to ignore. What happens if after 1 year you realize that the average inflation would be higher at 6% instead of 5%. Let us continue with the above case. At 6% inflation your monthly expenses after 10 years will be Rs.1,61,000. Your sum insured will also increase from Rs.3.53 crore to Rs.3.86 crore and your premium payout will go up proportionately.

Inflation remains one of the most important components of your financial plan. A reliable estimate of inflation is at the core of successful financial planning.