A reader asks, ” What should I consider as the average inflation rate for the next 25 years? RBI indicates an average of 4% but in a band of 2% to 6%.”
Assuming this is the inflation estimate before retirement, there are some considerations.
1. The inflation estimate is not set in stone. It is variable. Therefore, returns from asset classes would also vary. So, we should repeat the financial planning process once a year with fresh inputs and assumptions.
Although inflation can sharply increase or decrease in the short term, it is expected to come down over the long term gradually. When I started making financial planning calculations, 8% inflation was the norm for daily expenses without accounting for lifestyle changes.
Today, a good estimate for the corresponding figure is about 7% (plus lifestyle changes) before retirement. After retirement, we can reduce this to 6%. Hopefully, as the economy evolves, inflation will reduce further.
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2 Lifestyle changes contribute to inflation much more than price increases. I strongly recommend estimating the actual inflation for your family over the last 5 to 10 years. You can use this free tool: Personal Inflation Calculator.
Typically, this can be quite high – 9% to 12%. Even if you choose to use 7-8% inflation before retirement, the exercise will tell you that you perhaps need to slow down with the lifestyle changes (if they are wants and not needs).
3 Returns are linked to inflation! We cannot pressume inflation would be lower in future and use high return expectations! If inflaion falls, so too would returns. The useful thumbrule is overestimate inflation and underestimate returns! The results may not be pretty but it is better to be shocked now than surprised latter when nothing can be done.
4 Inflation estimates for other goals like children’s education or marriage should be much higher – 10% is the bare minimum, 12% is better!
5 Finally, for short-term goals, we combat inflation by investing more, not by taking more risk. For long-term goals we need both higher risk and investment to fight inflation. This is possible only if there is enough time on our hands.
Also read:
Rs. 100 in 1981 is now worth just Rs. 5 thanks to inflation!
Why you need time, money and returns to beat inflation
How to beat inflation after retirement along with guaranteed pension
Equity may beat inflation but that doesn’t mean you will!