What rate of inflation should I use for financial planning calculations?

Last Updated on November 16, 2022 at 8:07 am

A reader asks, “how do we decide the right rate of inflation to be used in financial planning calculations?” Let us first address the easy part: “What inflation rate NOT to use!”

Financial planning is a personalized exercise. All inputs and assumptions should reflect our personal circumstances. Therefore the rate of inflation we assume has nothing to do with the rate of inflation declared by government agencies. Media reports of inflation increasing or decreasing should have little to do with it.

Let us first consider the inflation estimate to be used for retirement. “What are your current expenses?” is one of the first inputs in a retirement calculator. This means you list all your current expenses that you think will persist after retirement. So you can safely exclude your home loan EMIs (unless you got the loan pretty late in life), any expenses for your children or parents etc.

Many people do not appreciate that retirement planning is not a one-time exercise. It is an annual exercise with revised inputs and assumptions. So your current expenses should reflect your actual “current” expenses each year.

Now, what is the most important factor that leads to an increase in expenses? Is it inflation, or is it a change in your lifestyle? For most people, it is the latter.

Remember, retirement planning aims to determine the corpus required (and therefore investment required) to maintain your current lifestyle. Most of us do not maintain our lifestyle. We constantly upgrade it. We cannot start living without these upgrades, like turning off a switch at retirement. See: How lifestyle inflation can impact our financial stability.

To some extent, the current expenses input during annual retirement planning reviews accounts for this lifestyle creep.

Now consider the rate at which essential expenses increase. This may or may not reflect the official inflation numbers. Often it is higher.

Therefore to account for a realistic increase in essential expenses and to factor in lifestyle creep, we recommend using at least 7%-8% inflation before retirement. After retirement, this inflation can be reduced by about 1%.

Inflation estimate to be used for other goals: Even 10% inflation is often not an accurate representation because there are too many uncertainties. For example, IIT and IIM fees stay the same for years and are suddenly hiked by 50%.

Realistic rates of college fee hikes mentioned by readers who have tracked them for years range from 12% to 15%. This is a very tough ask. An overall portfolio return after tax can’t be higher than this. So the investment amount required will be steep.

Sadly, most people cannot stomach the results of a goal planning exercise if the inflation is any higher than 10% (or 6-7% for retirement planning). So we recommend trying to invest as much as possible to try and combat this insufficiency.

We summarize with a few thumb rules:

• Do not use “current inflation rates” the government declares for financial planning. Use actual data. Either consider the rate of inflation of your expenses (for retirement) or the rate of inflation of the service or product you wish to buy.
• Avoid extreme stances. Never make the mistake of either assuming fixed income alone can beat inflation or equity alone (as in the dominant contribution) can beat inflation. We need the right balance of both asset classes. We also need adequate investment to beat inflation. See: There is more to investing than just getting high returns!
• When in doubt, err on the side of caution: Assume higher inflation and lower return rates in any financial planning exercise.