Do you know that Fixed Return Retirement Investments give you Nominal Returns? The biggest drawback of any Fixed Return Retirement Investment including PF (Provident Fund), NPS (National Pension Scheme) Fixed Return Schemes, Fixed Return Annuity and Fixed Return Retirement Schemes of Mutual Funds is that the Returns are not linked to Inflation. Hence if Inflation trends higher than the Returns offered on your Fixed Return Retirement Investments, at the time of your Retirement you will find that your Savings are not enough to meet your Retirement needs.
A simple example of Nominal Returns and Inflation will give you a good picture of the effects of price rise on Fixed Income Retirement Investments.
Assume that you invest Rs 100 in five year fixed deposit scheme of a bank that offers an interest rate of 9.5% per annum. At the time of investing in the fixed deposit, assume that you spend Rs 100 per year on your groceries.
The fixed deposit will give you a return of 9.5% every year or Rs 9.50 for the Rs 100 you have invested. If you invest in a cumulative scheme, your Rs 9.50 gets reinvested and at the end of five years you get back Rs 157 on your investment of Rs 100.
Inflation hits your grocery bill and at the end of five years your grocery bill goes up to Rs 200 per year. What does this mean? The cost of your groceries has gone up by Rs 100 over five years while the return on your fixed deposit is just Rs 57. Inflation has averaged close to 15% while the return on your fixed deposit has averaged 9.5%.
What has inflation done to your savings? Assume that you had not invested Rs 100 in fixed deposit but kept it as cash. In the first year, your grocery bill was Rs 100 and after five years it is Rs 200. Your Rs 100 could have paid for your grocery bill in the first year but in the fifth year, it can pay for only 50% of your grocery bill. Inflation has halved the value of your money.
To some extent you have made up for part of the price rise by investing in fixed deposit earning 9.5% but that still leaves you with a deficit at the end of five years and you have to eat into your savings of Rs 100 to the extent of rise in price of groceries less return on fixed deposit (Rs 100 – Rs 57.5 = Rs 42.5) to pay for your groceries. At the end of five years you are left only with Rs 57.5 to invest.
When you are earning, your income will hopefully rise with inflation and you may not feel the effects of rise in price of groceries. However when you are retired, your income earned on your savings may not be enough to pay for the rise in price of groceries and you end up eating into your capital.
How do you then beat inflation by investing in Fixed Income Retirement Schemes? You would have to be able to analyse if the government is protecting your savings by focusing on lowering inflation expectations and then adjust your savings in Fixed Income Retirement Products accordingly. You must understand trends in fiscal deficit, government debt, value of currency and global markets to understand economics of inflation. Socio-economic trends, consumption patterns and even factors like global warming have effects on your Retirement savings.
Your first step to optimize the value of your Fixed Income Retirement Investments is to understand Nominal Returns.