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Inflation, Savings and Life Insurance
We often hear the words ‘rising inflation’ and ‘rising interest rates’ but do we really understand these terms and the impacts they can have on us financially? What is inflation anyway and what does it have to do with the price of fish or the price of tomatoes which has received a lot of media attention lately?
More importantly, what impact does inflation have on your savings and in turn your retirement nest egg? Surely, it will not impact on your life insurance or does it?
- What is inflation?
- And the price of fish and tomatoes?
- Your savings and their returns
- Life insurance and inflation – a double-barrelled impact
Read on to find out exactly way understanding the impacts of inflation is important to your short and long term financial wellbeing.
What is inflation?
In economics, inflation is defined as a general progressive increase in prices of goods and services in an economy.
Simply put, inflation means that money is losing its value in that each unit of currency buys fewer goods and services which results in a reduction in the purchasing power of money. As the Reserve Bank (NZ) says “The underlying cause is usually that there is either too much money available to purchase too few goods and services or that demand in the economy is outpacing supply. In general, this situation occurs when an economy is so buoyant that there are widespread shortages of labour and materials. People can charge higher prices for the same goods or services”.
The common measure of inflation is the inflation rate, the annualised percentage change in a general price index. A price index is the average price statistically designed to help to compare how these prices, taken as a whole, differ between time periods.
The chart shows inflation per year since 1960. The Reserve Bank (NZ) has a remit to keep inflation between 1% and 3%, on average. They will use the Official Cash Rate (ORC) as their main tool for implementing monetary policy. They use the ORC to influence the 90-day bank bill rate. This in turn effects domestic interest rates and the foreign exchange rate. By altering these rates, the Reserve Bank has influence of the costs of borrowing money in New Zealand, and thereby influencing the level of activity and inflation in the economy.
And the price of fish (or tomatoes)?
The Consumers Price Index (CPI) measures the changing price of the goods and services that New Zealand households buy.
To calculate CPI a fixed ‘basket’ of goods and services is selected. Items are selected to determine their relative importance based on spending patterns. The items in the CPI basket represent how New Zealand households spend their money.
The prices of the goods and services in the basket are collected over time to measure how they change. You can find out about price changes for 11 CPI groups:
- housing and household utilities
- recreation and culture
- clothing and footwear
- alcoholic beverages and tobacco
- household contents and services
- miscellaneous goods and services.
Tied to the Consumer Price Index, is the consumer purchasing power this indicates the degree to which inflation affects consumers’ ability to buy. As a general rule, if income rises at the same rate as inflation, consumers can maintain their present standard of living.
For most of us the impacts of inflation is most noticeable when we go supermarket shopping. We sure do notice when things we buy everyday increase in price each time we go, hence the recent focus on the cost of tomatoes which have dramatically increased in cost when compared to this time last year or the years before.
If you want to have some fun, use the Reserve Bank of New Zealand’s inflation calculator to see what something that cost $1 in 2000 is priced at today. A declining purchasing power by nearly 39%.
The fish that may have cost you $9 per kilo ten years ago now costs you $10.62 per kilo. This might not seem that big of a change, until you think about all the other items in your shopping basket and all of that adds up especially if your income has not risen at the same rate.
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Your investments and their returns
As highlighted above while inflation erodes away your purchasing power, it also means your savings takes a hit.
Let’s look at what this actually means with an example. At the time of writing, an average 6-month term deposit rate is giving savers a return of about 1.6% per annum and the rate of inflation is at 5.9% per annum. This means that your savings, that money you have safely in your bank account is actually losing you 4.3% per annum. In other words it is costing you money to save it.
Your investments, especially your long term investments, should be giving you a return rate above the rate of inflation so they can continue growing and compounding for you.
You don’t want to reach your well-earned retirement years to discover that your nest egg is much smaller than you’d expected because inflation has eaten it away. In other words, you need to remain proactive to ensure you are keeping on top of inflation.
Life insurance and inflation – a double-barrelled impact
The impact on life insurance is more interesting, but it can also catch out if you are not aware. The premium for insurance is basically made up of three parts. For life insurance, the three main ones are age (each year you get older, the cost goes up), the price of the product, and CPI.
Many policies are indexed to CPI. This is a good thing as you want to make sure that the policy you bought 20+ years ago, is still ‘worth’ as much you wanted at the time you took it out.
Let’s go back to that calculator. Let’s assume you got a $500,000 life insurance policy in the first quarter (Q1) of 2000, but you did not have it linked to CPI (use the general category on the calculator). If you died today, your family will get $500,000. That might be enough, but in today’s money, that money is actually worth $816,109 (2021 Q4). That would mean your family are potentially short by $300,000 in today’s money. (The caveat here is that circumstances may have changed so you might only need less, but we are keeping this example simple).
The next part in all of this though, the double-barrelled part, is the premium. If you don’t link your premium to CPI, then your premium will not increase by as much, i.e it is not keeping up with the cost of living. In short, you will be paying for less benefit and your premium will only be determined by your age and the price of the product.
However, if you do have your life insurances linked to inflation, you can potentially see quite large price increases over the years, not just due to the CPI, but because the sum insured is increasing too.
This is why having a good adviser is really important as they will talk to you about what you want to achieve and will help you understand the cost versus the pay-off to make this happen.
[My Disclosure statement can be found here]
Dominic started Bolster Risk Management to help people along their personal finance journey.
He believes that personal insurance is the bedrock to financial security and wealth creation. You have to protect your greatest asset, your ability to earn an income.
Underpinning this is a philosophy that says Your Money Matters.