Inflation how it Impacts Your Retirement Income with formula and examples

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Marketopedia / Importance of Personal Finance / Inflation how it Impacts Your Retirement Income with formula and examples

What is inflation and example?

 

 

Without inflation, our financial calculations would turn out to be accurate: Rs.12,000,000/- in 2044 would comfortably fund our retirement up until 2064 with a monthly income of Rs.50,000/-.

 

Inflation is a reality that complicates life in many ways. For instance, something like a plate of pav bhaji from the same restaurant can change from Rs.50 to Rs.55 in the duration of one year – this slight increase is caused by inflation’s effect on the purchasing power of money.

 

It is a fact that, if all else remains the same, money today will always be worth less in the future. This is why our parents and grandparents could get a full meal for less than Rs.2/- – a story which has been passed down to us from one generation to the next.

 

This implies that today’s Rs.50,000 will not be the same amount in the future. Inflation will reduce its value, so it is not possible to solve the problem by simply multiplying the required amount with the number of years.

 

– The Future Value

 

To determine the solution, we need to understand the worth of Rs.50,000/- in 25 years. This knowledge was acquired from the preceding chapter.

 

The anticipated cash requirement is recorded here –

 

The table is easy to comprehend; the first row states that 2044 will be the 1st retirement year, which is 25 years from let’s say 2019. Through each of the retirement years, Rs.600,000/- will be needed for corpus. This amount remains unchanged through all the retirement years.

 

Let’s say the current year is 2019, and the 2nd retirement age will be 2045 – 26 years from now.

 

We must now find out the future value of Rs.600,000/- over a period of 25 to 27 years. This calculation is based on a certain level of inflation and will help us determine the amount we can expect at the end of this period.

 

Estimating the future value of the corpus

 

To continue our estimations for the corpus required in 2044, at the start of retirement, we need to consider the rate of long-term inflation.

 

I would comfortably place the long-term average inflation at 4-5%. So, if we consider a 5% rate of inflation, what would Rs. 600,000 be worth in 25 years?

 

By factoring in 5% inflation, we can calculate the value of Rs. 600,000/- 26 years from now and continue to do so until retirement in 20 years’ time.

 

Recalling the earlier chapter, the future value calculation is being discussed. After gathering all the figures, the total corpus required at retirement will be determined by summing them.

 

Let’s apply it for the first couple of years and then use MS Excel to compute the rest.

 

As we have seen in the preceding section, the formula for calculating future value is –

 

Future value = P*(1+R)^(n)

 

Where,

 

P= Principal i.e. Rs.600,000/-

 

R = opportunity cost; in this context, it is the inflation rate, so 5%

 

n = Period, 25 in this scenario

 

Adding these numbers –

 

600,000*(1+5%)^(25)

 

= Rs.2,031,813/-

 

In 25 years, Rs.2,031,813 will be equivalent to the purchasing power of Rs.600,000 today.

 

For the 2nd year –

 

600,000*(1+5%)^(26)

 

= Rs.2,133,404/-

 

If you wait 26 years, you will have Rs.2,133,404/- which is the equivalent of Rs.600,000/- in current terms.

 

and so on and so forth.

 

This excel snapshot reveals how much this amount is compared to other years. Test your intuition and guess before you take a look.

 

Most people I’ve surveyed on this subject have underestimated the value; this is because they do not understand that inflation and compound interest (future value) are involved.

 

Take a peek at the real figure, and hopefully, it will correspond with your guess. Even if not, don’t fret; we are all still learning.

 

Clearly, an extraordinary sum of money is needed in the opening months of retirement; 7.2Crs to be exact.

 

If we adjust the inflation expectation and the amount of money we need for our lifestyle, the figures change significantly.

 

– Oversimplification

 

Certain realities have been oversimplified and exaggerated here. For example, 50k may not be a monthly constant requirement. As we age, going to the trendiest bar in town may cease to be appealing; instead, we might just want to stay home with a cold drink. We could also reduce any external expenses such as dining out and watching movies. We could even opt out of buying the latest products from Levis or Nike. It’s hard to say for certain.

 

The amount of money needed in retirement may vary greatly. My research has led me to believe that the financial requirements of older people are less than those of younger people. Therefore, we most likely won’t need 50K per month once we reach retirement age.

 

When it comes to personal finance, it is definitely wiser to take a conservative approach and consider the potential result. Living comfortably but frugally will benefit us in the long term; however, budgeting for expenses is always necessary.

 

In the following chapter, we will explore methods for creating revenue.

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