Inflation is often understood as the rate at which prices of goods and services increase, but in reality the effect of inflation is far more destructive: it erodes the purchasing power of money.
For example, in 2009, a loaf of bread cost R5. Today, a loaf of bread costs R10, which means R5 will now only buy half a loaf of bread. Many would assume that inflation has increased the cost of bread, but the truth is that it is not the loaf of bread that has become more expensive, it is the value of R5 that has halved. This means that you need twice the amount of money today to buy the same loaf of bread you bought five years ago.
Time value of money
In financial circles, this is referred to as the “time value of money” – the very real phenomenon that the value, or purchasing power, of money halves around every seven years, depending on the inflation rate. This means that in seven years’ time, you will only be able to buy with this R5 what you can buy with R2.50 today – a quarter of a loaf of bread.
Effect on investments
When the ravages of inflation are considered in the context of retirement funds, it is clear why only 5% of South Africans who have retirement plans will be able to retire financially independent.
Let’s say that your retirement fund projects that you will have R22-million by retirement in 40 years’ time. What that R22-million will be worth in 2054 will depend greatly on the average inflation rate over the next 40 years, but two hypothetical scenarios will illustrate the point.
In the second scenario, in which inflation averages 8% over the next 40 years, your R22-million retirement fund will be equivalent to receiving around R850 000 today. That means that in 40 years’ time, when you retire, you will be able to buy with your R22 million retirement fund what you can buy with R850 000 today. Even if the inflation rate averages 5%, as in the first scenario, how long would you be able to sustain your current lifestyle with the equivalent of R2.9-million?
As it is the rate of inflation that determines how rapidly the purchasing power of money is eroded, and what investment returns will be worth at retirement, it is absolutely crucial to ensure that an investment provides a hedge against the ravages of inflation.
Hedging the risk
One investment that has proven to outperform inflation is buy-to-let property. Firstly, property price growth, while experiencing short-term fluctuations, continues to keep pace with inflation over the long-term. In fact, it is widely recognised that inflation boosts physical asset prices like gold, silver, oil and property.
Secondly, and similarly, the monthly rental income generated by a buy-to-let property keeps pace with inflation year after year, as the rental increases each year by the amount stipulated in the lease – generally 10% – or at least the inflation rate. This means that the income is hedged against inflation and will still have the same purchasing power – the rental of an average house – in 2024.
Buy-to-let property provides a real hedge against inflation, ensuring the value of your investments do not halve every seven years, but rather maintain their value, regardless of what the inflation rate may be.
P3 Investment Group