Inflation reduces your cash...

 

 

By WACEKE NDUATI OMANGA
Posted  Saturday, February 2  2013 at  02:00

In Summary

• ..so plan well for it

The many responses I received from last week’s article have inspired this week’s theme on inflation. Many of my readers wrote to tell me they can relate with Peter’s story regarding lack of proper planning for retirement, misunderstanding what a true investment is, and delusional thinking that the company pension fund is all you need for retirement.

Inflation is a word thrown around often when people are talking about money, but few really ever want to come to grips with what it means for them and their financial planning.

Inflation is the overall increase in prices of goods and services over time. Your lifestyle as you know it today will not cost the same next year, the year after, or in 10 years. So, in a nutshell, you cannot plan for the future with today’s prices in mind.

Inflation is the reason fuel, bread, electricity, rent, property, school fees were much cheaper five years ago than they are today. To put this into planning perspective, let us use a few illustrations:

Education Planning: Mary’s son will be going to university in 10 years. The university she would like him to go to costs Sh500,000 a year today. Mary wants to avoid the headache of raising university fees and wants to start saving early.

She invests in a savings plan that will pay out Sh500,000 a year for four years in 10 years’ time. Fast forward 10 years and Mary is stranded. Let us say school fees over this period was increasing at 10 per cent every year.

Next year, that course will cost Sh550,000, Sh605,000 the year after that, and so on. In 10 years when her son is ready for college, each year of school that currently costs Sh500,000 today will cost just under Sh1,300 000 a year.

Mary at this point will probably blame the provider of her savings plan, but she simply did not understand how inflation would impact her planning.

Retirement Planning: Joseph’s lifestyle currently costs Sh100,000 a month. He wants to retire in 15 years. Like many people, he believes that it is his employer’s responsibility and the managers of the company pension fund to pay him a sufficient lump sum to enjoy his sunset years in the same lifestyle he has grown accustomed to.

Let us again assume that cost of his lifestyle increases by 10 per cent every year. This means that to live in the same area, buy the same brand of products, enjoy the same entertainment, it will cost him Sh110,000 next year, Sh121,000 the year after that, and so on.

When he wants to retire in 15 years, this lifestyle that costs Sh100,000 today will cost Sh417,000 a month then. With this calculation you can now see why your company pension is not sufficient to fund your retirement.

In this time, Joseph should have been working towards building true investments (and I do not mean a home) that can actually generate this income. If he does not do this, Joseph will have no option but to cut down significantly on his lifestyle and go back to work.

For many people in our programme, this realisation is the biggest wake-up call of all as planning with future’s numbers in mind starts to put a new perspective on your current spending decisions as well as motivating you to keep trying to earn more.

The good news is that this “time value of money” concept also has a positive effect on your savings/investments. If you decide to carry lunch from home and save Sh10,000 a month earning 10 per cent per annum, in 10 years that will be worth about Sh2,000,000 at the time (assuming all returns are reinvested).

So you can see Mary can actually fund a good portion of her child’s university fees just from lunch savings. Your earnings over time will also increase and so should your ability to invest (rather than just your spending). Do not underestimate the impact of small consistent savings and always remember to plan for the future.