Partially inflation-linked pension

A pension that never grows loses real value every year prices rise. A pension that grows exactly with inflation never loses value at all. Most real pensions sit somewhere in between, and the workbook's Case 4 is built around exactly that middle ground.

Mr Smart's pension adjusts partially with inflation, to the extent of 50%, so if inflation runs at 6% in a year, his pension rises by only 3%. The other half of the erosion is his problem to solve, not the pension scheme's.

The case's figures. Mr Smart, 60, has just retired on a pension of Rs 4,80,000 a year, received yearly in advance, adjusting 50% with inflation. His wife, 58, continues to receive it for her lifetime if he dies first. Inflation is assumed at 6% a year; life expectancy is 87 for him and 85 for her.

Why the shortfall matters. If inflation is 6% and the pension rises by only 3%, which is 50% of 6%, the pension's real, inflation-adjusted value erodes every year, a widening gap between what the couple actually needs to maintain their lifestyle and what the pension pays. The couple also wants Rs 1,00,000 a year, itself inflation-adjusted at 6%, for social occasions and travel, layering a fresh, fully inflation-linked need on top of an already-eroding pension.

How the shortfall is funded. The couple's Rs 40,00,000 after-tax retirement corpus is meant to plug both gaps: the 50% of inflation the pension does not cover, plus the Rs 1,00,000-a-year discretionary spending. The case tests whether that corpus, discounted at an assumed rate, is enough, and one of its answer options shows it is not, unless the corpus can earn a materially higher return than a safe discount rate would assume.

Discounting the inflation-adjustment shortfall at 5% a year, with the adjustment required assumed to arise in full at the start of each year, the workbook's own answer is Rs 76,36,867, higher than the Rs 40,00,000 corpus Mr Smart has available.

That single comparison is the point of the case: a pension that is only partially inflation-linked can create a funding gap larger than the retiree's entire liquid corpus, even though the pension itself, in nominal rupees, looks like a comfortable Rs 4,80,000 a year. The gap exists purely because half of every year's inflation is never made up by the pension itself, and it compounds for as long as both spouses live, a horizon of 27 years to Mr Smart's assumed life expectancy of 87.

Chapter 20, Case 4, is built entirely around Mr Smart's partially inflation-linked pension, asking candidates to compute the corpus required to compensate for the inflation shortfall and to compare it against the Rs 40,00,000 available. Expect a present-value-style computation using the 50% inflation-linking, the 6% inflation assumption, and a stated discount rate.

• 50% inflation-linked means the pension rises by half the inflation rate, not that half the pension is protected and half is not. A common misreading.
• The shortfall compounds over the whole retirement horizon, not just one year. Case 4 runs it to life expectancy, 87 and 85, which is what makes the required corpus so large relative to the pension's nominal value.
• The Rs 1,00,000 discretionary spending goal is separate from, and fully inflation-linked in addition to, the pension shortfall. Do not net them into one figure without reading the question's exact ask.
• A pension that looks generous in year one can still leave a large real gap. The nominal Rs 4,80,000 a year is not the number that matters; the inflation-adjusted shortfall is.