Financial Planning and Inflation

1. Introduction

How can financial planning be carried out to take inflation into account? I wish to recommend a simple approach.

2. Education Fund

Assume that you wish to save $100,000 for the tertiary education of your child in 20 years time.

If you expect to earn an average return to be 5% a year, you need to save $3,020 a year.

In 20 years time, the cost of education would have increased, due to the impact of inflation. If inflation is an average of 2% per year, the cost would have increased to $148,000, i.e. an increase of 48% over 20 years.

To get the higher sum of $148,000, you will need to save 48% more, or $4,470. That is a lot of money, especially at the earlier years, when your income is still at a more modest level (i.e. has not reached the peak for your career).

A better approach is to have a saving plan that increases with your salary. If you assume that your saving can increase by 2% per year, you can save a smaller sum at the start.

3. Allow for Inflation

Here is an easy way to calculate the amount that you need to save to produce $100,000 (in real value) in 20 years, allowing for inflation at 2% per year.

If you expect to earn an average of 5% per year, and you wish to allow for inflation at 2% per year, you use a “real” interest rate of 3% in your calculation (i.e. nominal rate of 5% less inflation adjustment of 2%).

To get $100,000 in real value in 20 years’ time, you need to save $3,720 yearly in real terms, i.e. the saving has to increase by 2% every year.

4. Retirement Fund

A Central Provident Fund member is required to set aside a Minimum Sum of $99,600 on reaching age 55. This Minimum Sum will be adjusted yearly to allow for inflation. The CPF now uses an adjustment of 2% per year.

We can use the real rate of interest of 2% to compute the drawdown of the Minimum Sum.

At present, the CPF member can draw down the Minimum Sum for age 62. The Government is giving a Deferment Bonus to encourage people to delay the draw down to age 65.

If I use the real rate of 2% to calculate the accumulation of the Minimum Sum to age 65 and draws down this sum over 25 years, the drawdown is $6,200 a year or $518 a month. This reflects the value of money today. The “nominal” amount will be higher, due to inflation.

Many people consider $518 a month to be inadequate. I estimate that a retiree should have two times of the Minimum Sum to achieve a more comfortable standard of living. This can be achieved by keeping a larger portion of the CPF savings in the special account or by having personal savings to supplement the CPF savings.

5. Higher Return

It is extremely important to have an adequate real rate of return on your savings. The following table shows how the monthly drawdown changes according to the real rate of investment return:

Monthly Drawdown at age 65, from the Minimum Sum

6. Financial Planning Tips

1) Invest to achieve a real rate of return of 3%. This requires you to get a nominal rate of 5%. You can achieve this by investing in a low cost equity fund over 10 years or more.

2) Avoid financial products that give a nominal rate of return of less than 3.5% per annum. After adjusting for inflation, the real return is less than 1.5% a year. Most life insurance products fall into this category due to the high charges for distribution and life insurance protection.

3) Aim to achieve two times of the Minimum Sum from your CPF and personal savings.

4) Invest in a life annuity that can give a real rate of return of at least 3% per annum. It allows you to have a higher payout amount (compared to a 25 year drawdown plan) and guarantees you the payout for a lifetime.