Saturday, January 7, 2012

[] Impact of inflation on Retirement Planning


Most people underestimate the impact 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 is defined as a sustained increase in the general level of prices for goods and services. It is measured as an annual percentage increase. As inflation rises, every rupee you own buys a smaller percentage of a good or service.  Measuring inflation is a difficult problem for government statisticians. To do this, a number of goods that are representative of the economy are put together into what is referred to as a "market basket." The cost of this basket is then compared over time. This results in a price index, which is the cost of the market basket today as a percentage of the cost of that identical basket in the starting year.

The value of a currency does not stay constant when there is variation in inflation. The value of a currency is observed in terms of purchasing power, which is the real, tangible goods that money can buy. When inflation goes up, there is a decline in the purchasing power of money. For example, if the inflation rate is 7% annually, then theoretically a Re.1 cost an item now will cost Re. 1.07 in a year. After inflation, your currency can't buy the same goods it could beforehand.  In short for an ordinary man the cost of living will go up proportionately, you need to pay more money to buy same quantity of the goods you purchased earlier.
To pick an average inflation rate to use for future estimates would require you to make some estimate about where you think the economy is headed. We're currently in a period of high inflation (9-10%), but inflation has frequently been over 5%.  As per RBI predications, the inflation will be under control by the end of this financial year and it is estimated that, the inflation will be 7-8% by end of this financial year(April,2012)
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.
Causes of Inflation
The following are the main reasons for the inflation

 Demand-Pull Inflation - This is  simply can be summarized as "too much money chasing too few goods". In other words, if demand is growing faster than supply, prices will increase. This usually occurs in growing economies.  In short people have lot of surplus money in their hands but the supply of the goods is limited.

Cost-Push Inflation - When manufacturing costs go up, companies need to increase prices of the goods to maintain their profit margins. Increased costs can include things such as wages, taxes, or increased costs of imports etc.  This can also case due to the increases in the bank rates by RBI.  In that case companies needs to pay more on account of interest payments for the loan they availed from the banks for business purposes.

Result of Inflation

Inflation affects different people in different ways. It also depends on whether inflation is anticipated or unanticipated. If the inflation rate corresponds to what the majority of people are expecting (anticipated inflation), then we can compensate and the cost isn't high. For example, banks can vary their interest rates and workers can negotiate contracts that include automatic wage hikes as the price level goes up.

Problems arise when there is unanticipated inflation:

a)     Borrowers needs to pay more interest for the loan amount
b)    The prices of all essential commodities will go up consequently creating financial problems for those who are earning fixed amount of salary, pension etc.   This will lead to a decline in their purchasing power.
c)     Bank interest rates will go up which leads to hike in loan interest like housing loan, automobile loans etc
d)    Uncertainty about what will happen next makes corporations and consumers less likely to spend. This hurts economic output in the long run.
e)     If the inflation rate is greater than that of other countries, domestic products become less competitive.
Other Economic Situations
1)     Deflation - is just opposite of inflation, in this situation the general level of prices is falling.
2)     Hyperinflation – is usually rapid inflation.  In extreme cases, this can lead to the breakdown of a nation's monetary system.
3)     Stagflation – is the combination of high unemployment and economic stagnation with inflation.
Finally, inflation is a sign that an economy is growing. In some situations, little inflation (may be less than 1% or near to deflation) can be just as bad as high inflation. This was happened in India just 2 years back.  Immediately Government had taken remedial steps and brought that under control. The lack of inflation may be an indication that the economy is weakening. It is very difficult to judge whether inflation is good or bad, it mainly depends on the situation of overall economy as well as your personal situation.  Inflation may be good for one person, similarly bad for another.  In case the inflation is rising similarly wages are also raising proportionately in that case hike in the prices of goods will automatically adjusted in the wage hike.
Hope you enjoyed this article and I have not missed any major points. If so, do not forget to send your comments.
Best Regards
Prakash Nair

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