Life Expectancy

One of the important issues discussed in a previous post, Salary Curve, is how to make savings last beyond retirement. This is obviously tied to how much the income earner (and spouse) is expected to live post retirement. If the subjects leave this world five years after retirement, most likely their savings will last till the end.

But for Indians, the equation has changed dramatically within the last few generations.

Let us look at some world bank data for India [1] for life expectancy at birth.

LifeExpectancyIndia

The trend is quite consistent.  Life expectancy is seen to increase by one year every two years – that is, by 10 years every generation (20 years [2]). Life expectancy in many European nations was about 80-82 years in 2014, compared to 68 years for India. This leads me to expect that the upward trend in the graph is likely to continue for another decade, although the rate of increase has already tapered off to one year every 2.5 years.

One can draw some disturbing conclusions from this data:

  • A person can expect a life expectancy to be higher by about 10-20 years compared to his parents and grandparents.  Financial planning will therefore be different than what was needed by parents and grandparents
  • Increasing life expectancy means a larger burden being placed on future generations – having to take care of grandparents as well as parents. And who knows, maybe great-grandparents too.

[1] Life Expectancy data

[2] Generation gap

Inflation

We mentioned, in “Salary Curve”, that total lifetime savings equaling sum of (income – expenditure) as shown in the last curve does not work out in practice because of inflation. Let’s dig deeper into the meaning of inflation, how inflation may be measured, and what it means to you and me in daily life.

Defining Inflation

The qualitative meaning of inflation is simple enough: a sustained rise in general price levels in goods and services in an economy over a period of time [1]. So for example, Rupee prices of bread, soap, and toothpaste in the corner grocery shop near my house are higher today than they were a few years ago.  So it is clear that prices inflate (or currency deflates). A very narrow “point” definition of inflation can be given without much disagreement as follows:

For a specific commodity at a specific location, if its prices at two times T1 and T2  are P1 and P2 respectively (where T1 > T2),

Inflation=P1divP2

The above gives a multiplier. An alternative formula measures the percentage rate of change:

InflationPercentformula

Computing Inflation

Giving a single quantitative definition that everyone would find useful, however, is not easy. The problem is that ‘point’ inflation varies across commodities, across locations, and across times. It is rather like the concept of density in a non-uniform material.

So one has to develop a method to somehow average these countless point inflation values into a single meaningful value. There are several choices to be made:

  1. How to ‘mix’ the price of two commodities, say soap and SUV.
  2. How to select a manageable number of commodities from the millions of goods and services out there. Do we include soap? Which brands? Which sizes? Which packages?
  3. How to select the locality or area over which prices are to be collected. Town, District, State, Country, …? Or by socio-economic group?
  4. How to select the time interval.

Long story short, the accepted methodology is to calculate a number, called a consumer price index (CPI) at a given time and in a given area as follows:

CPI_formula

The Pi values are average prices for specific commodities over the desired area, and wi values are weighting factors that fine tune the contribution coming from each commodity.

This set of commodities is called a basket of commodities.

The rationale for introducing weighting factors comes from quantifying how much money a typical family with typical needs would spend in a month. This can be explained with a simplified example: Consider a family who consumes, on average, the following quantities in a month:

  • soap : 2
  • Toothpaste: ½
  • Bread: 24 loaves

 

Then a price index based on a basket of {soap, toothpaste, bread} will have the weighting factors {2, ½, 24} respectively. Note the prices and weighting factors must be in consistent units.

Although a single CPI value is not very useful by itself, but CPI values c1, c2 for two times T1, T2, (T1 < T2) can be used to measure inflation in terms of the rate of rise of CPI with time.

CPI_inflation

If the time interval is 1 year, this gives a yearly inflation rate. If the time interval is 1 month, the yearly rate is derived by appropriate adjustment.

An example of a real-life CPI basket that is specified by Govt of India is described in [3], see Annexure V, pages 137- 144, in particular.

Fuzziness in Inflation Numbers

CPI numbers as published by Govt of India or World Bank have many assumptions and approximations. For example, the basket used for CPI is not that meaningful for the very rich or the very poor. Averaging over a large area or population smears out local idiosyncrasies. The composition of the basket has to be adjusted from time to time to accommodate changing trends.

What it Means to You and Me

CPI-based inflation numbers show a trend. What is really important is not whether inflation is really 6.21 % or 6.53 %, but that in the long term, inflation becomes a force that is very dangerous to your and my financial well-being. But this line of thought will be followed up in a separate article.

Everything is Too Expensive

The other side effect of sustained inflation is that we generally get stressed out because our sense of prices of things lags behind reality. Our expectation of the price of a loaf of bread is probably its price we stored in memory some years ago (most people buy a bunch of things at a time and never pay attention to individual prices). Our expectations often become “anchored” to an earlier year. I suspect that older people are anchored to earlier times than younger people.

Another way to think about this is, everything is not getting expensive really, it is just that the currency is losing its value, year on year.

Unfortunately, when it comes to salaries, this anchoring effect may lull us into a false sense of comfort: what one is getting paid today, even if it feels like a comfortable salary, is probably not much higher than our expectations that are still anchored to salary levels of a few years back. In fact, current salary may be less than earlier years’ salary after taking inflation into account.

Finding Your Anchor Year

So let’s try an experiment. Find a common commodity where you are not aware of its current price. Write down what you feel would be its price today, F. Then find out the actual current price P.

The ratio P/F gives you a multiplier, which is a measure of mismatch between your view of prices and the reality. If you are in India, use the table below to find the closest matching cumulative inflation multiplier and read off the year in the previous column (If outside India, you can construct your own table from [4]). The table below was built from data in [5].

Notice that the multiplier values increase as you go back in past. Consider that the multiplier is 2.01 for 2008. For example, if you feel that a thing that you expect to be priced Rs 50 is actually Rs 100 today, then P = 100, F = 50,  P/F = 2.0, hence you are mentally still in 2008 for this particular item!

This procedure gives you your anchoring year for a particular commodity. Repeat for several different commodities and see if you get a consistent value for the anchoring year. You can now use the multiplier of your average anchoring year to revise all your price estimates upward.That should somewhat reduce the stress from the feeling of paying too much every time you shop.

This anchoring effect works in reverse on income too. So you should  divide your current salary number by the same multiplier, so that you develop a more realistically prudent approach to spending.

 

YEAR Mult YEAR Mult YEAR Mult YEAR Mult
2016 1.00 2006 2.26 1996 3.92 1986 9.71
2015 1.06 2005 2.38 1995 4.30 1985 10.40
2014 1.13 2004 2.47 1994 4.70 1984 10.94
2013 1.23 2003 2.56 1993 5.11 1983 12.31
2012 1.37 2002 2.65 1992 5.52 1982 13.30
2011 1.45 2001 2.78 1991 6.24 1981 14.99
2010 1.59 2000 2.88 1990 7.09 1980 16.35
2009 1.83 1999 2.89 1989 7.48 1979 18.27
2008 2.008 1998 3.34 1988 8.13 1978 18.54
2007 2.118 1997 3.55 1987 8.89 1977 20.00

 Table : cumulative inflation multiplier with 2016 as reference (India)

Takeaways

Inflation is the slow but inexorable rise of prices, or conversely, the inexorable loss of value of a currency.

Inflation may lead to shopping stress – “everything is so expensive” – because we often are mentally anchored to price points of an earlier time. Because of this anchoring, it may also lull us into a false sense of security when it comes to current and future incomes.

So inflation may be a mere annoyance in the short term, but over a longer time span. if inflation is not taken into account, it can seriously upset our financial calculations.

References

[1]  Inflation https://en.wikipedia.org/wiki/Inflation

[2]  Consumer Price Index https://en.wikipedia.org/wiki/Consumer_price_index

[3]  CPI Manual India 2010 http://mospi.nic.in/Mospi_New/upload/manual_cpi_2010.pdf

[4]  World Bank Inflation data http://data.worldbank.org/indicator/FP.CPI.TOTL.ZG

[5]  India CPI 1958-2015 http://www.inflation.eu/inflation-rates/india/historic-inflation/cpi-inflation-india.aspx

Salary Curve

study hard, get a good job, save money in bank fixed deposits, and live happily ever after” – traditional middle class mantra.

Most people choose employment as the means for earning a living. The words, “steady job” conveys a sense of security to friends and family. The initial years of experience in a job do add value so that rise in pay in the first few years is pretty good. However, salaries are ultimately dictated by the law of supply and demand. Unless the person develops a skill that is highly in demand, the law works in favor of the employer. The older employee cannot bring higher value to the table, and so the salaries flatten out after about age 40 [‘pay goes nowhere after 40’]. A plot of a annual salary versus age in a particular year will look like Figure 1. Notice there is an initial high premium commanded for the initial years of experience.

Note: I believe this curve will hold true even where job skills change frequently, such as in information technology, because such variable job skills are a small part of the overall experience for which employers are willing to pay a premium. But like heart attacks, perhaps salary flattening might show up at earlier ages than before.

 

money101-Fig01-b

Figure 1: Annual salaries versus employee experience

For an employee starting out in a career, this fact of life is useful to know. Penelope Trunk has sound advice  on how to delay the post-40 flattening. However, Figure 1 is based on data of a large number of employees at a particular point in time. Can one draw a similar curve for a particular person’s 40 year work span? Yes, but one additional factor needs to be taken into account for such long duration: the effect of inflation that changes the value of currency from year to year. For a more meaningful analysis, all salary amounts should be in terms of currency value of a reference year (i.e. discounted for inflation). For example, if salary increases the next year by 10% but rate of inflation was 6%, then real salary increase is only 4%. This leads us to Figure 2. The curve drops to zero at retirement.

money101-fig02-b

Figure 2: Real salary history for a particular employee

I view this curve as half the financial story of the middle class life. The other half involves looking at annual expenditures for the employee and his or her dependents. A prudent family makes sure the expenditure curve stays below the take-home pay. See Figure 3 below.

Although salary drops to zero at retirement, notice that the expenditure curve continues much longer. The point to note is this: The area between income and expenditure in earlier years = savings (marked in green), is the buffer that has to be preserved and grown in order to meet the expenses for employee and dependents for the remaining years (shown in red).

money101-fig03-b

Figure 3: Income, Expenditure, and Savings

Would it suffice, then, to make sure that the savings (area in green) is larger than the later year expenses (area in red)? Unfortunately, the situation is more complicated than that. Over such a long duration, inflation plays a major role. If savings are not protected against inflation, they will lose most of their original value by the time they are needed.

Bottom line: the traditional middle class mantra, “study hard, get a good job, save money in fixed deposits, and live happily ever after”, stopped working — several years … nay, several decades ago.

[PS: Thanks Ketaki T, Sumit K for your feedback]