Ask someone how much they need for their child’s higher education and they will usually quote what it costs today. The fees will be paid many years from now, at the prices of that time. The gap between those two figures is inflation, and for long-term goals it is often the largest single factor in the calculation.
What inflation is
Inflation is the general rise in prices over time. As prices rise, each rupee buys a little less. The effect in any one year is modest. Over long periods it compounds, in the same way that investment growth compounds, and the cumulative effect is large.
The published inflation rate is an average across a basket of goods and services. Your own experience can differ, because the things you spend on may be rising faster or slower than the average.
Why it matters more for some goals
- Long horizons. The further away a goal is, the more years inflation has to work. Retirement, which may be decades away and then last for decades more, is the clearest case.
- Costs that rise faster than average. Education and healthcare costs have often risen faster than general prices. A goal built around them needs a higher assumption than the headline rate.
- Goals that are a stream of spending, not one payment. Retirement is not a single bill. Expenses continue to rise every year after you stop earning, so the planning has to cover the whole period.
For short-term goals a year or two away, inflation matters much less than making sure the money is there on the day.
Nominal and real: two ways of counting
A nominal figure is the number of rupees. A real figure is what those rupees can buy. If an investment grows over a period but prices grow just as fast, the nominal value is higher and the real value is unchanged.
This is why keeping long-term money only where it does not fluctuate carries a risk of its own. The amount in the statement never falls, but its purchasing power can. Avoiding market risk entirely means accepting inflation risk instead. Neither choice is free of risk, and the right balance depends on the horizon of each goal.
How to estimate a future cost
The method is simple, and it is worth understanding even if a calculator does the arithmetic.
- Start with what the goal would cost at today’s prices.
- Choose the number of years until you need the money.
- Choose an inflation assumption suited to that kind of expense.
- Compound today’s cost at that rate for that number of years.
The result is a working estimate of the future cost. From there you can work out what you would need to set aside regularly, using a second assumption: the rate of return on the investment.
Every estimate rests on assumptions
Notice that the calculation above uses two figures that nobody knows in advance: future inflation and future investment returns. Small changes in either produce large changes in the answer over long periods. For that reason:
- Treat any figure as an illustration, not a forecast. The calculators on this website use assumed rates that you can change, and their results are illustrative only.
- Try more than one assumption. Seeing a cautious case and a more optimistic case side by side is more useful than a single number.
- Do not assume high returns in order to make the required saving look affordable. That is the most common way plans fall short.
- Mutual fund returns are not guaranteed, so a plan should leave room for outcomes that are worse than the assumption.
Planning habits that help
- Review the estimate every year or two. Update today’s cost, the years remaining and your assumptions. A plan that is revised regularly does not need to be right the first time.
- Increase contributions as income grows. A fixed monthly amount shrinks in real terms every year. Raising it periodically, for example through a step-up SIP, keeps your saving in line with rising costs.
- Separate goals by horizon. Long-horizon goals need to be invested with inflation in mind. Short-horizon goals need stability more than growth.
- Keep flexibility in view. If a goal’s date or size can be adjusted, an unfavourable period is easier to absorb.
The point to take away
Inflation is quiet and steady, which makes it easy to leave out. Including it turns a comforting number into a realistic one. It is better to see the realistic figure early, while there is time to act on it, than to discover it when the goal arrives.
Any estimates we help you prepare are planning inputs incidental to mutual fund distribution. They are illustrations based on assumptions, not predictions.