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At the beginning of the year, we gave you a glimpse of the best financial advice given to celebrities . We began with master showman, Shah Rukh Khan, who recalled what his mother told him: “The time and energy spent on plugging holes could be more constructively used in trying to increase income.” Those words have a special significance today, when the inflation rate seems to be spiralling out of control. There’s little we can do to control inflation.

What lies in our power is to ensure that our purchasing power is not hit too badly. And that, in most cases, means holding out for larger salaries. But consider this. As the inflation rate rises, more people will start demanding higher wages, increasing the cost to companies, which means that they will increase their selling price, leading to inflation. It’s a vicious cycle (also see “Money Illusion”). Of course, companies could refuse to pay more, which would result in a lower standard of living.

The way out is to try and increase productivity at work. This might not necessarily lead to an immediate financial gain, but it will ultimately result in an increase in your market value. If more people do this, the overall productivity will improve, costs and prices could fall.... Yes, it sounds simplistic, but it makes sense. You might want to try it in the current scenario.

How inflation deflates your income and investments

Your income + your investment = your purchasing power. This is the commonly understood definition of purchasing power. But this is wrong. The miss- ing element in this equation is the inflation rate. Here’s a demonstration of how and by how much inflation actually deflates the value of your income and investments.

Assumptions

Starting investment: Rs 1,00,000
Annual return on investment: 10%
Annual salary: Rs 2,40,000
Annual salary increment: 7%
Annual inflation: 4.3%
Inflation-adjusted returns: 5.47%
Inflation-adjusted increment: 2.59%

 

• With a 10% annual return, a corpus of Rs 1 lakh becomes an impressive Rs 45.26 lakh in 40 years (Column B)

• Combined with salary increments, the total corpus grows to Rs 81.19 lakh—a stupendous growth of 2288% in 40 years (Column D)

• Even a low annual inflation rate of 4.3% reduces the purchasing power of Rs 81.19 lakh to just Rs 15.07 lakh (Column E)

• The real value of the corpus at the end of 40 years is a minuscule 18.56% of its notional value

• The current rate of inflation is three times the rate assumed in this example, though over time it will stabilise to a lower level

• Most planners assume the longterm inflation to be 6-8%

• The table shows calculations for 40 years, assuming it to be maximum working life of an adult, who starts earning at 20 years

• People older than 20 years can understand the impact of inflation by considering the number of years between their current age and 60 (marked on the left of the table)

• To know more about the impact of inflation on your purchasing power, write to us at mtportfolio@intoday.com

Salaries matter

If you don’t want to start cutting down on expenses, you have little option but to look at ways to increase your income. We look at how you can inflation-proof your investments, but you should also consider how to maximise your salary. The table below (with data from Hewitt Associates) shows how salaries have kept pace with the inflation rate over the years. The forecast indicates that the gap between salary hikes and the inflation rate is narrowing. This, despite the proof that salaries have already gone up substantially; the income-tax department reports that there has been a 71% increase in the income tax collections in the first two months of the year.

Of course, this is not cause for immediate panic, but it is a sign that you should be doing something about widening that gap. The good news is that most families no longer rely on the earnings of a single member; they have two, if not more, earning members. This means that even if individual salaries cannot beat the inflation rate, there’s every chance that the family’s total income could do so.