Sunday, 22 March 2015

Inflation : Cost Inflation Index

Inflation is a well known "Retirement Killer".  Long term goals like Retirement, Children's Education, Children's Marriage, etc are highly susceptible to the ravages of inflation, since the long term nature allows for massive compounding of the ill effects of high inflation.

Cost Inflation Index is the fancy term that the Indian Income Tax Service uses to quantitatively measure inflation.  This is a reasonably good measure of inflation, since the Indian government effectively chooses to waive any taxes if your investment is growing in line with the CII.  There are many websites you can read up to understand how CII works.  In effect it says that if your investment grew at the same pace as CII, you will not owe any taxes on the growth, since the Indian government acknowledges that your "growth" is only notional and not real.  

So I consider CII as a pretty darned good lower limit for inflation indexed returns.  Your investments have to grow faster than atleast the CII to be able to keep up with inflation.  If they grow slower than the CII, then even the Income Tax Dept believes that you have not made any real money, and you will owe no tax on that investment growth!

Here is how the CII has progressed over the last ~35 years.  The solid blue line in the graph below represents the CII which is referenced to 100 in 1981-1982 (The CII is reported for each Financial Year, which corresponds to 2 consecutive calendar years: from Apr1 of the current year to Mar31 of the next year)

I have next done a curve fit to the CII, using a CAGR of 7.3% represented by the dotted red line in the graph.  The curve fit is pretty decent, which shows that on average, your money can grow at 7.3% per year, and still be considered tax free (as long the tax code allows for inflation indexation)

7.3% might sound like a small number, but when compounded over multiple years, it can make a serious dent in the value of your investment.  Consider a period of 20 years from 1996 to 2015.  In 20 years the CII went up from 281 to 1024 which is about 3.65 times.  So if you had invested say 20 Lakhs in a flat in 1996, the flat better be worth atleast 20 x 3.65 = 73 Lakhs today to stay abreast of inflation as defined by the taxman!  

With the rapid growth in real estate values over the last couple of decades, hopefully your real estate investments have grown manifold in value, and not just by 3.65 times.  This same principle can be applied to any other investment that you are trying to benchmark.  If you had put money into debt instruments, hopefully the value of the debt instruments has grown faster than 3.65X in 2 decades, else in reality you have lost money!

Like I mentioned in the article before, I believe CII is more like the lower bound to inflation indexed returns.  In reality inflation runs hotter than represented by CII, and hence you actually have to beat CII by quite a margin (upto 2% points) to really create wealth.

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