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Why do you need to beat the inflation?

Updated: Sep 6, 2020

This is the fourth article in the series explaining the importance of knowing your financial health. We covered why we need to save money, how to assess our financial health, explored the various asset classes and how to approach asset allocation. But we did not cover how asset allocation affects us in the long term. Here is a perspective...


The fundamental money related question any individual would have is, do I have adequate money to support a comfortable life until I expire? To answer this, you need to look at projections of your money matters into the future. What would be my income and expenses 20-30 years ahead? Would I have enough corpus after I retire? How long would my corpus last if there is no primary income? You need to do a projection of your current balance sheet into the future to see if you are in the right direction or if you need to take corrective action.


For the purpose of explanation, let us assume some numbers to do a sample projection. Let’s take an imaginary person aged 35 Years, who has a take home salary of Rs. 7.2 lakhs per annum and spends 50% of this money towards all expenses including debt commitments. So the yearly outflow is Rs. 3.6 lakhs, while an equal amount is available for investments. For simplicity’s sake, we will not be considering the wealth accumulated by this person until this point. This is to consider that the person’s expenses would have been on the higher side due to initial settling down costs of adulthood for the first 10-15 years after graduation. With these parameters defined, the average life expectancy in India is almost 70 years, meaning we will project this person’s money needs for the next 35 years until 2055. In addition, we will also assume, this person retires early due to personal or forced reasons by the age of 50, i.e., 2035. The primary income stops at 50 years of age, but the person needs to support his expenses for the next 20 years.


With all the personal parameters set, now, let’s see how his current income might grow for these 15 years he would be in service. Considering all hikes the person would receive, including yearly hikes, bonuses, promotions etc, let's assume the average yearly hike to be 8%.


Coming to his expenses, we need to look at India’s inflation rate over the past 25 years (1994-2018). The inflation rate is dynamic and it has fluctuated between as low as 2.5% and as high as 13.3%. On averaging, this comes to 7.02%, meaning we would assume this person’s expenses grow at a rate of 7.02% each year. Now let me pause here for a moment and let you check and think about the current FD interest rates you are getting. Needless to say, it is not sufficient to beat inflation after paying taxes on it.


India Inflation Rates For Last 25 Years
India Inflation Rates

Now, it’s time for some number crunching. We are starting with 3.6 lakhs expenditure and if we compound this at a rate of 7.02%, at the end of 35 years (Ageing 70 Years), the person’s expenditure would be whopping 38.6 lakhs per year. The expense has increased about 12 times! Shocking? You shouldn’t be. Because, when bankers entice you with the “power of compounding” to invest with them, you should also remember that the same power of compounding works on your expenses too. Luckily, we will be applying compounding to the income as well at a higher rate of 8%, but remember that we are assuming the person will retire at some point in the future. So on compounding 7.2 lakhs over a period of 15 years at a rate of 8%, the income would be 22.8 lakhs per annum at the age of 50 Years.


Now, the person has saved 50% of the income each year and this saved money is the corpus and this is what would feed the person for the next 20 years after retirement (Ageing 50 Years). So let’s assume, the person wishes not to cut down on the expenses and wants to lead the same lifestyle as when he was earning. We will project how long this corpus would last based on 3 investment scenarios.


1. Doesn’t Invest The Savings


Obviously, no sane person would do this, but for the sake of explaining how quickly the corpus gets used up, we will project how long the person has enough money to support the expenses. At the time of retirement, the person would have a cumulative corpus of 1.17 Crores saved. By continuing the expense at the rate of average inflation (7.02%), the person would be bankrupt in just 8 year, while there is still 12 more years to survive!

Whatever you save will be spent quicker than the time you spent in earning them. There can’t be a better example of why investments are needed.



2. Invests at a rate of 6% (Less than Inflation Rate)


If the person wants to play very safe and wishes to only invest in FDs, the interest might not even match the inflation after tax. Taking the developed countries as an example, the FD interest rates have been falling on the long run. India would too face the same fate as the focus remains on growth, thus pushing traditional depositors to become investors. Let us assume, over a period of 35 years, the FD rates after tax outflows is pegged at 6% (best of best case) , do you think the person will be liquid until expiry? Unfortunately the answer is no, At the age of retirement, the savings which were invested at the rate of 6% compounds and grows to 1.7 Crores. Since the person intends to be invested, even after a portion of the corpus is used for expenses, the remaining amount would still be generating some interests and on cumulatively compounding the savings after each year’s expense outflow, the person still gets bankrupt after 15 years. The performance is far better though but still not enough to make it till the end.



3. Invests at 7.6% (Higher than Inflation Rate)


The person breaks even at the end of 70 years of age (2055) when the money is invested at 7.6%. The person retires with a cumulative savings of 1.89 Crores and without sacrificing on the comforts, the person should be investing the money at a rate higher than inflation to make it till the end.



It is quite evident why you need to invest money and why you need to invest at inflation beating rates from this example. The more you beat the inflation, the better. If you are a beneficiary of a pension scheme, that is a bonus. And this example did not consider any medical expenditures or any other emergency expense which are inevitable over a 35 year period. To mitigate the unknowns, you need to build your emergency funds in addition to adequate insurance covers. This might lead to more expenses but they are extremely important than the lifestyle expenses that you make and priority needs to be given first to emergency funds, insurances and investments. Do not let lifestyle inflation add to your woes caused by the unavoidable retail inflation.


To achieve the inflation beating returns, there are a lot of safe as well as riskier options available. You can beat inflation by making use of appropriate allocation to Govt’s debt schemes, GOI Savings Bonds, Sovereign Gold Bonds, PPF, EPF, Pension schemes etc which are safer. The rates are bound to change, but it is expected to accommodate for inflation projection, hence this should help you in the battle to be neck to neck on matching inflation. But to beat inflation, riskier assets should be explored. Mutual funds have large categorisation which offers inflation beating returns on the long run. Based on the last 10 year trailing returns, the various categories under mutual funds have given 2%-13% depending on the type of fund. On averaging, this comes to 7.95% across categories. By investing in the right funds and with due diligence on risk management, the returns from mutual funds can sufficiently beat inflation even with a lower exposure to it.



 

This probably sets a context on how you should approach asset allocation. You can do the same exercise as mentioned in the article by changing the parameters that are applicable to project your income and expenses. Start reviewing your asset allocations. If you require a copy of the excel sheet that I used, please reach out to us on Facebook (https://www.facebook.com/GetFinsight) / Twitter (https://twitter.com/getfinsight) and we can send the copy to you. You can also mail us at get.finsight@gmail.com.


Until Next Time, Stay Invested!


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sales qurio
sales qurio
Nov 08, 2021

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Get Finsight
Get Finsight
Nov 27, 2021
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