Inflation eats away at retirement funding
The main measure of inflation in South Africa is the Consumer Price Index (CPI). This indicator is compiled on a monthly basis by Statistics South Africa, and is used by the South African Reserve Bank to determine the impact of its interest rate policy.
Despite upward pressure on the prices of domestic consumer goods, CPI has remained steadfastly within the 3% to 6% target range set by the Reserve Bank. Earlier this year, most economic analysts predicted that inflation would worsen during the first three quarters of 2007, before improving slightly. None expected CPI to break through the 6% ceiling. In February 2007, CPI came in at 5.7%.
The level and impact of inflation is important to investors and investment advisers alike. Estimates of general inflation are used in almost every financial planning calculation - along with estimates of investment returns and the likely prevailing interest rates.
Inflation destroys purchasing power
The reason is that inflation erodes the value of money. Inflation results in today's R1, 000 being worth much less in the future. To demonstrate this loss of purchasing power, consider an inflationary environment of 6% per annum.
The R1, 000 in your pocket today will be worth only R747.30 in 5 year's time. After 10 years, the same R1, 000 will be worth only R558.40. And in 20 years time your R1, 000 will only be able to purchase R311.80 of goods at todays prices. If your retirement income is unable to compensate for the price erosion caused by inflation, your future standard of living will suffer immeasurably.
If you have R100, 000 invested in a money market account, and you receive 10.5% interest per annum, your nominal return is 10.5%. Your real return is this 10.5% less inflation of 6% (or 4.5%). And you still have to factor in the effect of taxation! You and your adviser have to plan to provide a real rate of return on your invested funds to compensate for the effect of inflation.
Inflation is a major thorn in the side of pensioners because they do not have the benefit of the 'guaranteed' inflation-linked wage increases they would have enjoyed while in full time employment. That's why news of pension fund increases is always welcomed by pensioners. Recently, Old Mutual announced increases of between 6.5% and 11% on their Platinum Pension Portfolio funds. This increase beat CPI and CPIX which managed 5.8% and 5% for the 12 months to December 2006.
Level income not the best bet
Today's discussion on inflation was triggered by an article in the Sunday Times, Money section. In this article, Chris Willis of Alexander Forbes discussed the virtues of purchasing a level annuity.
At face value it seems that purchasing a level annuity and re-investing excess income from the monthly annuity makes sense. But such a strategy carries excessive risk for two reasons. Firstly, providing inflation beating returns on short-term investments can be difficult - especially in the event of unexpected economic shocks. And secondly, the discipline required to invest the surplus income is often lacking. In general, South African consumers exhibit rather alarming propensities to spend rather than save.
All things being equal, the better option is to purchase an escalating annuity to provide rising income to compensate for the eroding effects of inflation.
The problem with the Consumer Price Index
The Consumer Price Index in South Africa has been below 6% per annum for some time now. We need to consider whether this inflation measure provides an accurate reflection on the impact of higher prices on ordinary South Africans? Is the basket of goods used to calculate the figure appropriate - or does it need to be revised?
When we consider the above inflation increases in the prices of fuel, food and medical cover it begs the question whether the 5.7% CPI measure is a true reflection of inflation as experienced by individual consumers. Another consideration is that the percentage of disposable income spent on food, luxury goods, transport and medical aids is radically different for low, middle and high-income earners. The greater proportion of your monthly expenditure dedicated to the above categories of goods, the greater the impact of inflation on your disposable income.
Given these facts, it may be prudent to add a percent or two to the expected inflation number when doing your retirement calculations!
Editor's thoughts:
The South African Reserve Bank is trying to keep inflation in a narrow 3% to 6% range. Do you feel that the current retirement and annuity products are able to provide inflation beating returns? Send your comments to [email protected].
