Inflation risk

Inflation risk is not the risk of losing money. It is the risk of keeping every rupee and losing what those rupees buy.

The workbook is specific about where it concentrates: fixed-return instruments — bonds, deposits, debentures — where the investor is paid a fixed periodic interest and handed back the same principal at maturity. The rupee amounts are certain. Their real value is not, and it falls every year.

It is also specific about who it hurts: retired people, whose income flows tend to be fixed in absolute terms. A salary negotiates itself upward. A pension cheque of a fixed number does not.

Two features make a product vulnerable. The payout is fixed in rupees, and the term is long. A five-year deposit loses a little real value; a level annuity running 25 to 30 years loses most of it.

The workbook prescribes two defences, and neither is to abandon fixed income:

• Shorten maturities within the debt allocation, so the portfolio can reprice into the higher interest rates that usually accompany inflation.
• Hold an inflation-hedging asset class — equity or commodities — for part of the portfolio.

Its sizing rule for retirement income is the practical version of the same idea: size the annuity so that essential, mandatory expenses stay covered even after long-run real erosion, and fund discretionary expenses from growth assets.

Real value of a fixed payment after n years = Payment ÷ (1 + inflation)^n

A 3 percent simple step-up raises the nominal payment arithmetically, not geometrically:

Payment in year n = Initial payment × (1 + 0.03 × n)

That is why it cannot keep pace with inflation compounding at 5 to 6 percent — the workbook calls it partial protection, and the arithmetic says why.

A retiree annuitises part of her NPS corpus and buys a level annuity of Rs 50,000 a month, the ordinary "annuity payable for life at uniform rate". The workbook notes that Indian inflation has historically averaged 5 to 6 percent over long horizons and that a retirement now runs 25 to 30 years. Take 6 percent.

The cheque never changes. What it buys does:

By year 25 she has lost 77 percent of her standard of living without missing a single payment.

Now buy the only stepped option the workbook lists, annuity for life increasing at the simple rate of 3 percent:

Year 25 nominal = 50,000 × (1 + 0.03 × 25) = 50,000 × 1.75 = Rs 87,500
Year 25 real    = 87,500 ÷ (1.06)^25       = Rs 20,387

The step-up nearly doubles the cheque and still leaves her with 41 percent of what she started with. That is precisely what the workbook means by partial protection — and why it tells advisers to cover only essential expenses from the annuity.

Chapter 2, section 2.6 (Common Risks in Investments) defines inflation risk and names fixed-return instruments and retirees as the points of maximum exposure. Chapter 4, section 4.2.3 applies it to NPS annuity options — the passage on the 3 percent simple step-up is written to be examined — and Chapter 7, section 7.3 lists it as a "con" against annuities, deposits, POMIS and SCSS in turn. Expect questions asking which retirement income product carries the most inflation risk, and conceptual questions on why the adviser recommends equity exposure to a retiree at all.

• Inflation risk is highest where price risk is lowest. A government-guaranteed deposit has no default risk and the most inflation risk. Candidates who rank products by "safety" get this backwards.
• A 3 percent simple step-up is not inflation indexation. Simple growth is arithmetic, inflation is geometric; the gap widens every year.
• Do not confuse it with re-investment risk. Inflation risk is the erosion of what a payment buys. Re-investment risk is being forced to redeploy a maturing deposit at a lower rate. Both hurt a retiree and the workbook lists them separately in section 2.6.
• It is a distribution-stage problem as much as an accumulation one. During accumulation, inflation raises the corpus you need; during distribution it shrinks the income you draw. The workbook treats both in section 3.5.
• "Fixed income" does not mean "fixed real income". The predictability of the rupee amount is the source of the risk, not protection against it.
• Equity in a retiree's portfolio is not a contradiction. The workbook prescribes it as an inflation hedge for the discretionary half of expenses while keeping essentials annuitised.