5 Jul, 2014

How Inflation can affect your Financial Forecast while Planning?

Inflation is an essential part of Financial Planning for the planners as it affects both, the earning and expenditure aspect of the planning. The increase in inflation rates are usually followed by increase in interest rates to overcome the increasing inflation which in return affects the return on equity of the industries that are dependent highly on debt. The return on equity in these sectors is inversely proportional to rate of interest. On the other hand, with the increase in inflation, the client would require more money than forecasted for sustaining the same needs.


We can illustrate this with an example. Suppose a person would retire in another 25 years and needed to ensure that he could keep up with his current spending of Rs 100000 per annum for 20 years after retirement. The return on investment is 8%. If we consider 4% inflation, the amount of savings required at the time of investments are around Rs 38 lacs. If the actual inflation rate turns out to be around 8%, then the amount required at the time of retirement would be Rs 137 lacs, i.e. more than 3.5 times the amount.

It is very difficult for a financial planner to forecast the inflation rate. A slight increase in the inflation may cause problem for the client in the future. Playing too safe with the inflation rate again can create problem of diverting too much earnings into saving and thus affecting the current living standard. It is also observed that actual increase in the spending is much more than the inflation index because the basic commodities, like food, land, fuel and healthcare, those are essential for a living are more affected with the price rise than the average growth of the cost inflation index. So these factors should also be considered while making a financial plan.

Thus inflation plays an important part while designing a financial plan. If the prediction of the inflation goes wrong by even 1%, it can cause a lot of difference in the amount saved and the amount actually required. Regularly reviewing your financial plan can be a better option for the client as this would help him plan according to the current expenditure prices and thus help him prioritize his requirements.

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