Sunday, April 15, 2012

How inflation affects retirement savings


Most people underestimate the impact of inflation will have on their retirement plans. Even at relatively low rates, inflation is a real thief of buying power over time. Most experts feel safe recommending that individuals calculate their retirement needs using a 3-5% percent inflation rate. But, it is important to understand that we have sustained inflation rates of around 8-10%.  At an average annual rate of 3.75%, inflation will double approximately every 19 years. Use this as a rule of thumb to figure out how many times your cost of living will double by the time you need the money. Don’t use your retirement date as the endpoint for your retirement planning. Remember, you could easily live another 20-30 years or more in retirement — time enough for your cost of living to double yet again. Because of the compounding effect of inflation over time, failing to account for inflation in your retirement savings plan can be as devastating as losing more than half of your money. However, if you get an early start and make sensible investments, you can get the power of compound interest rates working for you rather than against you. 
 
Inflation may vary greatly from year to year, but keep that 3-5%  in the back of your mind before locking in any traditional bank term deposits or any other guaranteed fixed income generating financial instruments for a long term investment.  Also be sure to consider the impact of taxes. If you’re looking for a “safe” investment, it’s currently better to keep your bank deposits long and flexible — e.g., in a high-interest  fixed deposit  account or  FMP — upto the time the bank rates come down
 
Answering the question “How much do I need to save for retirement?” requires you to estimate how much you think you could live on after you retire. But, don’t forget about inflation.
 
Before we begin with our sample calculation, a word on inflation. When drawing up your retirement plan, it's simplest to express all your numbers in today's currency value. Then, after you've determined your retirement needs (in today's value), you can worry about converting the numbers into "tomorrow's inflation adjusted value. When you are finished, you can apply an inflation assumption to get a realistic estimate of the amounts you will be dealing with as you make your contributions over the decades
 
Now on to the sample calculation. Consider the hypothetical case of Mr. X, a 40-year-old man currently earning Rs.45,000 after taxes. Let's go through the key factors for Mr. X If you think you could live on Rs. 25,000.00 per month based on today’s prices, what would that be equivalent to 15-20 years from now? We can’t predict exactly what inflation will be in the future, but that doesn’t mean you shouldn’t include inflation in your planning.
 
For example, let’s say you plan to retire in 20 years. If we assume that inflation will be an annual 2%, then to maintain the same spending habits that a yearly income of Rs.75,000 affords you today, your starting income at retirement would need to be  Rs. 111,446.
 
Lot of peoples does not consider inflation while planning their future especially retirement planning. The temptation of “instant satisfaction” does not allow one to plan and invest for future at the cost of present day financial situation. The retirement looks too far away. Put things in perspective and things start to look scary.  Go ahead, enjoy life, but please do not forget what the future may look like. Control your current expenses and have a good future. One’s lifestyle could be the greatest asset or the biggest liability. It is all in your hands.  
 
When you plan for future, it is useful to you to calculate the inflation adjusted future expense of your family compare with present expense. Knowing this fact is a must while doing the financial plan because of its capacity to predict and calculated inflation adjusted future returns from your investment portfolio.
 
What Does Inflation-Adjusted Return Mean?
 
 A measure of return that accounts for the return period's inflation rate. Inflation-adjusted return reveals the return on an investment after removing the effects of inflation. Removing the effects of inflation from the return of an investment allows the investor to see the true earning potential of the security, without external economic forces. For example, say an investor held a bond that returned 4% over one year. Examining only the return shows that this bond earned a positive income. However, if inflation for the year was 5%, the real rate of return on the bond becomes -1%. 
 
How much did your investments really earn last year? You can calculate a rate of return, but if you don’t adjust it for inflation and taxes, you’re not getting the real rate of return.  This is the difference between the nominal interest rate and the real interest rate. You want to know the real rate, since that is the only number that means anything.  Think of it this way: the nominal interest rate tells you the growth rate of your money, while the real interest rate tells you how much your purchasing power is growing.
 
For example, if make a Rs. 1,000 investment that earns 8% in one year, you end the year with Rs.1,080. In other words, your money has grown by Rs.80.  However if inflation is 3% for the year, your Rs.1,080 is only worth Rs. 1,050. Inflation devalues not only the interest you earned, but the principal too. Your real rate of return is only 5%. See Consumer Price Index. Investors depending on dividend income or interest from bonds or other fixed-income securities are most directly affected by the costs of inflation.  If you hold a stock, the gains build up until you sell, so it may be possible to avoid the “inflation tax” if you can time the sale for periods of low inflation.  Stocks can generally weather the effects of inflation better than bonds or other savings instruments. Companies can pass on the higher costs of inflation to customers. Of course, this tends to keep the inflationary cycle going.
 

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