How to calculate your personal inflation rate

Important gauge to determine wealth creation – retirement skills trainer.

Ingé Lamprecht Moneyweb 2017.02.02

JOHANNESBURG – South Africa’s year-on-year inflation rate as measured by the consumer price index (CPI) has remained stubbornly high, reaching 6.8% in December.

While this is already outside the Reserve Bank’s target band of 3% to 6%, one Moneyweb commentator recently argued that the buying power of many South Africans is eroding at a higher rate than the official figures suggest.

For the purpose of financial planning, this “gap” – real or perceived – is not that important, but understanding your personal inflation rate is.

Unless individuals and their advisors understand their personal inflation rate they may never really create much of a nest egg for retirement, says Dave Crawford, retirement skills trainer at Planning Retirement.

“The only solution seems to be for people to keep their personal inflation rate as low as possible to allow their investments to prosper.”

If your personal inflation rate is 9% and you invest in a portfolio targeting a return of CPI plus 3% in an environment where inflation is 6.8%, the return generated by the portfolio (an assumed 9.8%) doesn’t really help you to create wealth, Crawford says.

“And remember these returns need to be after costs have been deducted.”

But how do you calculate your personal inflation rate?

As a starting point, you need to calculate your standard of living.  In short, your living standard is what is left of your total monthly earnings (salary, bonus, allowances and other taxable income) after all the amounts that you don’t or can’t spend (taxes, contributions to savings and mortgage payments) are deducted.  An article previously published on Moneyweb explained how to do this in some detail. Calculating your standard of living is also an important starting point in determining whether you are on track to retire comfortably.

Determining your standard of living each year as part of the financial planning review process can also provide valuable insight into your personal inflation rate.

The table below sets out a simplified example. If the process is repeated each year, it could also be used to calculate your average inflation over time, which could be helpful if you need to adjust your living standard downward over time.

 

2016 2017
Total monthly earnings R21 250 R23 375
Tax (R2 500) (R2 700)
Savings
– Retirement (R2 500) (R3 525)
– Discretionary (R1 250) (R1 250)
Mortgage payments (R5 000) (R5 000)
Living standard R10 000 R10 900
Increase in spending   R900

 

The difference between your living standard in 2017 and 2016 (the percentage increase in spending) is effectively your personal inflation rate, Crawford explains.

In the above example it is equal to 9%. (Note that the total monthly earnings increased by 10%.)

“This creates an interesting situation.  If one’s investments only grow (after costs) by the [personal] inflation rate then they are merely maintaining their buying power.  The rate at which they grow above [personal] inflation is the real generator of wealth.”

Crawford says when a benchmark is established research suggests that behavioural changes follow measurement.

Once people know how to measure their personal inflation rates they are in a position to make changes.  Without measurement they remain in the dark and are just guessing, he says.

“Getting your personal inflation down is a major part of improving retirement preparation but the other factors still remain.  Keeping investment costs down is significant as is the allocation of assets.  Not to mention saving as much as you can.”

In the current investment environment, where returns are expected to be lower than they were over the past decade, investors may increasingly need to re-examine their living standard and make adjustments to ensure wealth creation.

Inflation remains one of the major problems in retirement provision planning Crawford says.