When thinking about the future, considering the time when you’ll no longer be working and will instead be relying on your own resources, there is one factor in particular which is often overlooked but which can do some serious damage to your plans. That silent killer? Inflation.
Just what is inflation, and why is it so important? Essentially, inflation as I’m describing it above relates to the general tendency for prices to rise over time; the increase in the cost of living. You’ll never really notice it from one day to the next, or one month to the next. Perhaps not even from one year to the next, but ignore it at your peril when you’re planning your financial future.
There are several official measures of inflation here in the UK. The best known are RPI, or the Retail Prices Index, and CPI, the Consumer Prices Index. CPI is the government’s inflation target, which has been set at 2% since 2003 (although it has exceeded the target on numerous occasions). Both indices track the prices of a basket of about 650 different types of goods; a pretty big basket. There are a number of differences between the two indices, the most well known being that RPI includes costs for housing such as mortgage interest payments and council tax.
Once criticism of these measures of inflation is that they are generic and not personalised. For example, what use is it to include mortgage interest if you don’t have a mortgage? In an ideal world, you’d be able to easily calculate your personal inflation rate based on your typical spending in an average year. Whilst this may be possible in theory, we’re not aware of any simple and reliable calculators to help with this just now. So basing your assumptions on one of these indices and keeping an eye on inflationary expectations is probably simplest.
So how does inflation kill a financial plan? Well think back to what you were earning 20 years ago. Imagine if you were earning exactly the same amount now. Would you be able to enjoy the same standard of living on the same amount of money? Highly doubtful. Let’s put some figures to it.
Imagine you spend £2,500 per month in total today, and that your income is just enough to cover this. In 10 years’ time, if your monthly costs have risen by 2% pa, your income would need to rise to £3,047 to cover your costs. Over 20 years, your income would need to increase to £3,715. If inflation is 3% the figures would be £3,360 and £4,515 respectively.
To put it another way, your income of £2,500 per month would be the equivalent of £1,682 per month after 20 years of inflation at 2%, or just £1,384 at 3%.
It can have a similar effect on money in the bank. Imagine £100,000 earning interest at 1%. After 10 years of inflation at 3% this would be the equivalent of £82,034. It would seem like the money is growing because your bank statement would show an increasing balance each month, but after inflation you’re losing money in real terms; your savings would buy less and less each year. Remind me, how long has the base rate been less than 1%? Well over 10 years.
This shows the massively damaging effect that inflation can have over time, and why it’s crucial to make sure you’re income and assets are protected against it. Be sure that your financial plan takes account of this silent serial killer.
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