We received several queries about last week’s discussion in this column on managing your standard of living with commodity investments.

One such question was: Is inflation an important factor for retirement portfolio, given the long-term nature of the investment? In this article, we discuss when and how you should consider inflation in your retirement portfolio.

Age factor

Inflation may not be an important factor when you have age on your side. That is, if you are 25 and plan to retire at 60, you need not be concerned about inflation during your retirement years. You should instead concentrate on your savings and investment process.

By this we mean that you should concentrate on saving every month and automatically transferring the money into an investment account through a systematic investment plan.

The power of compounding will work in your favour as far as your bond investments (including bank fixed deposits and your provident fund account) are concerned.

And with time on your side, you can typically recover losses, if any, on your equity investments as well.

So, when does inflation become an important variable in your retirement portfolio?

We believe that you should be more concerned about inflation after 45. Why? For one, beginning 45 is when you gradually consolidate your financial position and start seriously planning for your retirement.

By consolidation we mean that you will begin to reduce your liabilities as you approach retirement and also increase your savings as your income peaks.

And two, as you enter the consolidation phase of your lifecycle, you will also become aware of the expenses you are likely to incur to sustain your desired standard of living during your retirement years.

The question is: How should you consider inflation in your retirement portfolio?

Living expenses

Your spending needs post-retirement can be typically divided into three categories — leisure, living expenses and health care. Suppose you retire at 60 and live till 90.

You can divide your lifestyle needs into three 10-year buckets. If you are typical individual, you are more likely to travel during your first 10 years and cut your travel-related spending during the later years of your retirement.

Your health-care expenses, in contrast, will typically increase at 20-25 per cent for each 10-year bucket. Your living expenses will typically decline by 20-25 per cent during the first 10 years of retirement and further decline by 10-15 per cent between 71-80 and 81-90.

Now, inflation on health care and leisure is typically higher than that on living expenses. So, if you assume that your living expenses are likely to increase at 7-8 per cent a year during your retirement years, you should inflate your leisure expenses and health care at 12-15 per cent a year. Your exercise does not end there. Suppose at the beginning of 63, you need Rs 15 lakh for leisure, Rs 3 lakh for medical and Rs 12 lakh for living expenses for a total of 30 lakh.

When you retire at 60, you need Rs 26.20 lakh to have Rs 30 lakh at the beginning of 63. Why? Suffice it to know that Rs 26.20 can grow to Rs 30 lakh if you can earn 7 per cent interest a year for 2 years. You have to do similar calculations for other years as well.

Estimation process

Estimating your post-retirement spending needs and accordingly accumulating wealth during your working years can be a daunting task.

Adjusting for inflation is an important part of this estimation process. While forecasting 15-20 years ahead may appear futile, you can reduce the estimation error through logical and realistic assumptions based on current inflation levels. Failing to take inflation could result in you having lower-than-required wealth to meet your desired lifestyle during your retirement years.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to >knowledge@thehindu.co.in )

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