How inflation eats away your savings
The Sunday Nation
Nairobi,
21 August 2011
Last week’s article ended on the curious suggestion that a pay rise can make one poorer. The basic idea was that wealth is not measured in shillings, but in terms of the duration that one can stay without working before exhausting their savings. Thus the more you earn per month, the shorter your savings can sustain you!
We used the case of Rachel who earns Sh30,000 per month and found that, by saving 10 per cent of this for five years, she would accumulate about six months salary. However, when we include salary increments at the rate of 15 per cent per annum, the total savings came to about four and a half months. It appears then that she would be better off without a pay rise!
In doing that calculation, we assumed that the prices of commodities would remain constant during the period and so we expect the money saved to be able to buy the same quantity of goods five years down the line. But that is not a reasonable expectation.
In the first case where Rachel does not get any pay rise, the savings at the end of the first year came to Sh36,000. If the average inflation during the period is 10 per cent per annum, then the purchasing power of this amount reduces by this ratio every year.
That is, whatever she can buy with Sh36,000 today is likely to cost Sh39,600 after 12 months and therefore she wouldn’t afford it! Another way of looking at this is ask: what is today’s value of an item that will cost Sh36,000 in one year’s time? In other words, to what number would we add 10 per cent and get 36,000?
We get the answer by diving 36,000 by 1.1; the result is 32,727. That is, if the average inflation is 10 per cent per annum, the goods that you can buy with Sh32,727 today, will cost you Sh36,000 in one year’s time.
Now, in five years, Rachel will have saved Sh180,000. What is the equivalent value of this amount in today’s prices if the inflation remains at the average of 10 per cent per annum?
The accumulated inflation after five years is NOT 50 per cent! It is obtained by multiplying 1.1 by itself five times. This comes to 1.61, or 61 per cent. As we did before, we divide Sh180,000 by 1.61 to find the equivalent value of the savings. The result is Sh111,765.
But, Rachel is still earning Sh30,000 per year, therefore her savings are equivalent to about 3.7 months salary. Repeating the same calculation for the case when Rachel gets a 15 per cent increment per annum yields that she will be about three months wealthy after five years – still worse off!
Clearly then, we need a new method of setting the savings target: not in terms of shillings in the bank account, but in terms of the number of months of wealth.
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