Ruined by Inflation by Priya Sunder

I remember the first day we opened our office for business almost a decade ago. It was a spanking new workplace in the posh Lavelle Road area of Bangalore. We were waiting to welcome our first customer. Soon enough Ritu walked in. She was intrigued by our signage, which stated that we were financial planners. She told me her father never did anything called a financial plan. Yet he put his children through school and college, got them married and settled, and lived a fairly comfortable life himself. Why then was it important for her to be doing a financial plan?

Ritu raised an important point. Her dad had managed fine on his own. Why could she not manage her finances too? Why did she need us? I told her that four things were different during her father’s time– first, her father could take all his money and put it in a fixed deposit, where he could earn up to13% in annual interest. Second, he had fewer investment choices and hence making financial decisions were less complex; third, his life expectancy was lower than ours, which meant he worked till 58 and lived till 75. The shorter lifespan ensured that his assets could see him through retirement comfortably. Fourth, and most importantly, inflation was a low single-digit number during his time. A hundred rupees would be sufficient to take care of the grocery bills for an entire month!

Things are different in Ritu’s case. A bank fixed deposit interest can get her 10% at best. She has many more investment options today be it in mutual funds, insurance, stocks, fixed deposits, bonds etc. She has a longer life span. Statistics show that our lifespan is increasing by one year every three years. We are living in an age where inflation is averaging around 8%- 10%. A hundred rupees earned 30 years ago will buy you groceries worth Rs. 14 today! What’s more, many people want to retire early. A shorter working life with a longer lifespan translates to around 15-25 years of earnings and 35-40 years of retirement. It becomes critical to ensure that your assets grow fast enough to sustain you through your lifetime.

My customers often tell me that they are satisfied with the 9% interest on their fixed deposits. But have they considered that a 9% interest will yield only a little over 6% post tax (assuming a 30% tax bracket)? In the same period, inflation in our country is hovering at 10%. Hence the real return on the fixed deposit is a negative 4%. This means that they are becoming poorer every year without realizing it.

Let’s take the case of another customer of ours, Malini, who told me she had planned to buy a car last year. The cost of the car was  ₹5.6 lakhs. However, she decided to postpone the purchase to 2014 since she had planned to travel extensively last year. Malini invested the ₹5.6 lakhs in a bank fixed deposit that offered her an interest of 9.5%. When the deposit matured this year, she received  ₹6.13 lakhs.

Cheque ready in hand, she went to the showroom to purchase the car, and realized to her astonishment that the cost of the car had shot up from Rs. 5.6 lakhs to Rs. 6.5 lakhs, an increase of 16%. On the other hand, her investment in the fixed deposit had only appreciated by 9.5%. Post tax, her investment had appreciated by only 6.65%. A commodity that she could afford last year suddenly went beyond her reach this year. That is what inflation does. It slowly gnaws away at the purchasing power of your money, leaving you a little poorer every year.

Smart financial planning ensures that that the composite of all your investments offer you post tax returns that beat inflation year on year. What we need to focus on is the real return on an investment. Real return, or actual return minusinflation, is more important than notional return. A positive and healthy real return will ensure that you meet long-term goals such as college education funding and retirement planning comfortably, without running out of money midway through your goals.

In general, conventional debt investments such as fixed deposits have not offered returns that beat inflation. On average, the real returns from these instruments are negative. There are several other financial instruments that offer higher real returns. For example, Fixed Maturity Plans or other debt mutual funds offer better tax adjusted returns than fixed deposits if the investment is held for more than a year. Gains from equity and equity mutual funds are exempt from tax after a year and beat inflation over a longer time horizon.

The key to beating inflation is to have the right split between equity and bonds in your portfolio. As a general rule, your age is a good guideline for the proportion of bonds you should hold. If you are 40, then have 40% bonds and 60% in equity. Bonds bring safety in your portfolio. But you must choose bonds that offer tax benefits along with returns. Equity is more volatile, but over a longer time horizon, beats inflation comfortably. While investing in equity, mutual funds are a great way to enjoy the diversification of a well-managed portfolio while earning good returns.

Women tend to be risk averse, and prefer to invest more in bonds such as fixed deposits rather than equity. That along with low real and post tax returns will land your finances in double jeopardy. Paradoxical as it may seem, being risk averse can seriously endanger your financial independence.

Seven ways to beat the inflation blues

1. Invest in equity and equity mutual funds. Capital gains are tax exempt after a year. Additionally, dividends from stocks are tax free

2. Invest in debt mutual funds, which allow you to index your investment to inflation. The longer you stay invested, the lesser tax you pay

3. Open a public provident fund account and invest money in it every year. PPF maturity proceeds are tax exempt

4. Use a money market fund (liquid fund) to park your funds for the short term. Use it as a proxy for your savings account. It also earns you a higher interest than a savings bank account

5. For meeting short term goals such as annual vacations, school fees and insurance premium payments, start an SIP into a money manager debt fund instead of accumulating funds in your savings account. Your money will grow at a better rate. Redeem these funds when the need arises

6. Invest in inflation-indexed bonds that tie your principal to inflation. However investing in these bonds may not beat inflation if you are at a high tax bracket

7. Invest a proportion of your assets in gold ETFs and real estate. However, real estate should not occupy more than 60% of your overall assets