Purchasing power

Money is only worth what it can buy. Purchasing power is that "what it can buy", as distinct from the number printed on the note.

The workbook defines it as the value of a sum of money expressed in terms of the goods and services that can be acquired with it. When prices rise, the same Rs 100 buys a smaller basket, so its purchasing power has fallen even though it is still Rs 100.

For a retirement adviser this is the central problem. A salary tends to rise with prices. A fixed pension, a fixed annuity or the interest on a fixed deposit does not — so a retiree can receive every rupee promised and still become steadily poorer.

Inflation is the rate at which the general level of prices rises from one period to the next, measured in India by indices such as the Wholesale Price Index (WPI) and the Consumer Price Index (CPI). It reduces purchasing power by reducing the quantity of goods that can be acquired for the same income.

The workbook's illustrations at 6 percent inflation:

Three places in the paper where purchasing power drives the answer:

• Idle money loses real value, which is the workbook's opening argument for investing rather than merely saving.
• The real rate of return exists to tell the investor the actual purchasing power of an investment's value, not its nominal growth.
• Fixed-income retirement products. The workbook names the loss of purchasing power as the disadvantage of the annuity, and names inflation risk as highest in fixed-return instruments.

Future cost of today's basket  = Today's cost × (1 + inflation)^n

Today's purchasing power of a
fixed future sum                = Future sum ÷ (1 + inflation)^n

The workbook's case. Someone planning to live on Rs 60,000 a month at the start of retirement needs, at 6 percent inflation:

After 10 years:  60,000 × (1.06)^10 = Rs 1,07,451 a month
After 20 years:  60,000 × (1.06)^20 = Rs 1,92,428 a month

for exactly the same standard of living.

Turn it round (illustrative). A retiree has Rs 1 lakh a month of fixed income that never changes. At the same 6 percent, in today's rupees it buys:

Ten years in she has lost about 44 percent of her purchasing power; by year 25, more than three-quarters. No payment was missed and no capital was lost. That is why the workbook insists that a retirement corpus be sized on an inflating income, and why it recommends some growth assets even in a retiree's portfolio.

Chapter 1, section 1.2.1 (Inflation and Time value of money), defines purchasing power, and section 1.2.2 ties it to the real rate of return; one of Chapter 1's sample questions asks directly for the consequence of inflation. Chapter 2 (sections 2.2, 2.6 and 2.8) uses it to explain why savings must be invested and why fixed-return products carry inflation risk, and Chapter 3 (sections 3.2.4 and 3.4.2) applies it to the corpus and to annuity income. Expect the direction-of-effect question and a forward inflation computation.

• Inflation reduces purchasing power; it does not increase the value of money. The Chapter 1 sample question offers "appreciation in the purchasing power of money" as a distractor.
• Purchasing power is lost without any loss of capital. A guaranteed product protects the rupee amount, not what it buys.
• The retirement-income figure rises through retirement too. The workbook stresses that Rs 1,71,675 at the start of retirement is not the figure for the whole period; costs keep rising after the last pay cheque.
• Some expenses rise faster than the general rate. The workbook singles out health costs and travel as typically increasing at a higher rate than standard inflation.
• Not the same as inflation risk. Purchasing power is the quantity being eroded; inflation risk is the risk that an investment's payouts are worth less than expected because of that erosion.