Purchasing power is the number of goods or services that one unit of currency can purchase. It is literally, the power to purchase.
For example, one rupee can purchase much less today than it could purchase say twenty years ago. If your money income stays the same, but the prices of goods or services increases, then the purchasing power of your income is reduced.
This increase in the price level of goods and services is called Inflation.
So, your ‘real’ income refers to your income, adjusted for inflation.
Thus inflation is the increase in prices that erodes the purchasing power of your money.
And this is why inflation is the most important thing to account for when building your financial plan.
Let us see some scenarios where inflation has affected our financial goals.
Scenario 1
Mr. Gupta has a 6 year old daughter. He plans to send his daughter to college abroad for graduation at age 18 and post graduation at age 21, for which he will spend Rs 10 lakhs and Rs 25 lakhs respectively. These are the fees of a graduate and post graduate education today.
What corpus does Mr. Gupta need to accumulate for his daughter’s education goals?
Assuming that inflation in college fees is approximately 10% p.a:
If Mr. Gupta’s daughter goes to college at age 18 i.e. in 12 years, college fees at that time will be approximately Rs 31.40 lakhs.
This is the amount Mr. Gupta has to accumulate in 12 years to send his daughter for the same standard of college education available today at Rs 10 lakhs.
Similarly, for his daughter’s post graduation, in 15 years Mr. Gupta needs to accumulate approximately Rs 1.04 crore to give the same level of post graduate education available for Rs 25 lakhs today.
This is the effect inflation has had on college education fees.
Scenario 2
Mrs. Kapoor is currently 30 years old and wants to retire by the age of 50. On retirement, she wants to maintain her current lifestyle. She is currently spending approximately Rs 20,000 a month on household expenses, and approximately Rs 3 lakhs per annum on travel, medical and discretionary expenditure. (For a better understanding of discretionary expenditure, please see our article titled Spend Now, Achieve Your Goals Later)
What corpus does she need to live her life post retirement?
In order to maintain her current lifestyle, and assuming her post retirement life expectancy is another 35 years, Mrs. Kapoor will need Rs 13 crores to sustain her current lifestyle.
This Rs 13 crore corpus has to be invested into safe debt (i.e. fixed income) instruments and earn a 5.50% post tax interest on the amount. Both principal and interest will go towards sustaining her lifestyle for 35 years post retirement. At her 85th year (assuming 85 years life expectancy) the corpus will be depleted.
This is assuming a simple 7% rate of inflation on household expenditure, and a 10% rate of inflation on other expenditure.
This is the effect that inflation can, and will, have on your financial life.
Want to know how much you require to retire? Use PersonalFN’s Retirement Calculator
To see how inflation can burn the value of your money, simply see what happens if you invest in instruments that don’t match or beat inflation.
Let’s take a figure of Rs 10,000.
Assume an inflation rate of 10% and take a time period of 20 years.
In 20 years, you will need a figure of Rs 67,275 to have the same purchasing power as your Rs 10,000 today.
You have 3 choices of where to invest your Rs 10,000 today – the bank savings account, a debt mutual fund, and an equity mutual fund.
Let’s see how each one fares against an inflation rate of 10%.
| INSTRUMENT INVESTED IN |
FUTURE VALUE |
| SAVINGS ACCOUNT (3%) |
Rs 18,061 |
| DEBT (7.50%) |
Rs 42,479 |
| EQUITY (15%) |
Rs 163,665 |
The amount you require to simply keep the purchasing power of your money constant is Rs 67,275. Inflation at 10% has eaten into the value of your money so much that over 20 years, even investing in a debt product at 7.50% p.a. post tax (such as a long term FD) is not enough. You need to earn at least 10% post tax every year to just match inflation and keep the purchasing power of your money intact.
In the table above, it is only equity earning 15% p.a. that matches and beats inflation. You can also match and beat inflation by investing into a mix of equity and debt instruments i.e. diversifying your investments across different asset classes.
So remember, inflation can and will eat into the purchasing power of your income. It is important to invest wisely so that your investments can beat the rate of inflation and you can achieve your life goals.
An asset allocation across equity and debt will help you to achieve your goals and also protect your investment corpus.
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