Estimating Inflation And Periodic Investment Requirements Realistically
Adjusting the cost of a goal for inflation is an important aspect of the goal planning process. But it is also one of the most challenging aspects of the process. Therefore inflation estimates for financial goals must be as realistic as possible. There are two broad approaches to estimating inflation. And today I am going to talk about both these approaches and compare them. I will end by offering an opinion as to whether either approach offers more realistic results than the other.
The first of these approaches is the traditional approach. Here we adjust current costs for inflation by applying a certain rate of inflation for the entire tenure of the goal. The formula used for the same is given as follows :
Goal value = C(1+i)^n; where :
C = Current cost
i = inflation rate in decimals
n = number of years to the goal
An example of a goal with a current cost of Rs 1,00,000 inflating at 6% for 20 years is shown below.
The monthly investments required for the goal can then be arrived at using the PMT function. The PMT function has been described below.
PMT(rate, nper, PV, FV, type), where :
PMT = Periodic investment required
Rate = Rate of return/12 (since all calculations are on a monthly basis)
Nper = Tenure of the goal in terms of months
PV = Current value of investments made towards the goal (Assumed to be 0 by default)
FV = Target corpus required for the goal
Type = Point of time when the payment is required. Type 0 indicates payment is required at the end of the year. Type 1 indicates payment is required at the beginning of the year. By default, assume type 0.
In the instant case, assuming an 8.2% post tax portfolio return from a 60-40 equity-debt portfolio, the values may be substituted as follows :
Rate = 8.2%/12
Nper = 20 * 12 = 240 months
PV = 0
FV = Rs 3,20,714
Type = 0
These inputs give us a required monthly investment figure of Rs 531 per month.
The second approach is called the back of the envelope approach. Here calculations are redone once a year with actual figures. Applying the back of the envelope approach to the example above would yield the results shown below.
One year later, assume the current cost of the goal has increased to Rs 1,20,000 and the value of the portfolio for the goal is Rs 5,000. Accordingly the calculations can be reflected as shown below.
In this way, the current cost of the goal and the monthly investments required can be assessed on a year on year basis. The gap between the value of the portfolio and the current cost of the goal should come to zero when the goal falls due. This shows that we have consistently invested enough for the goal. Let us now compare the traditional and back of the envelope approaches. The traditional approach is optimised for calculations through MS Excel and online goal calculators. Therefore, carrying out the calculations is just a question of having the required inputs in place.
But the major drawback of this approach is that inflation and return rates are assumed. Assumptions are subjective and may vary from one person or financial planner to the other. The actual rate of inflation and returns applicable over the tenure of the goal may vary from the rates assumed. The back of the envelope approach on the other hand requires updated calculations every year. Because of this inflation would automatically be baked into the figures with each annual review. This negates the need for assumptions with regard to inflation rates. This results in a more realistic estimate of inflation and periodic investments required. The only thing to keep in mind when using the back of the envelope approach is that we would have to redo calculations for each goal on an annual basis.
We would therefore need to have a fair estimate of the current cost of the goal for each passing year. Even so, the back of the envelope approach proves to be more realistic than the traditional approach. It may therefore be a wiser choice to adopt the back of the envelope approach over the traditional approach when estimating inflation and required periodic investments.