Inflation & Real Returns

Real returns = nominal returns minus inflation; key for retirement planning. Education only.

The 10-second version

Nominal return is what your account grows by in rupees. Real return adjusts for inflation and tells you how much purchasing power grew. For life goals—especially retirement—real returns are what matter. A portfolio compounding at 8% with 6% inflation delivers only ~2% real growth.

Core idea in one line

Focus on what your money can buy, not just how big the number looks.

Definitions & formula

  • Nominal return (Rn): growth rate without adjusting for inflation.
  • Inflation (π): rise in the general price level (e.g., CPI).
  • Real return (Rr) (exact): Rr = (1 + Rn)/(1 + π) − 1
  • Approximation (good for small rates): Rr ≈ Rn − π

Example: 8% nominal with 6% inflation → real ≈ 1.9% exact (not 2.0%—rounding).

Why real returns matter

  • Retirement income: Your spending must keep pace with prices for 25–35+ years.
  • Goal planning: Education, healthcare, and housing often inflate faster than headline CPI.
  • Comparability: Real returns let you compare across time and regimes with different inflation levels.

Taxes and the “double drag”

Taxes are levied on nominal gains. Your real, after-tax return is lower than it looks: 

R_real_after_tax ≈ [(1 + R_n × (1 − tax)) / (1 + π)] − 1

High inflation + taxable nominal gains can compress real outcomes. Use tax-efficient wrappers/funds where available and minimize churn.

How to plan in “real” terms

  1. Express goals in today’s rupees (e.g., ₹12 lakh/year lifestyle).
  2. Use inflation-linked growth for expenses (e.g., 5–6% pa for general basket; adjust if your personal inflation differs).
  3. Assume real returns for assets (e.g., equities 4–6% real over long runs; high-quality bonds near 0–2% real depending on yields).
  4. Back-solve corpus and safe withdrawal rules using real assumptions (e.g., 3–4% real SWR baseline with guardrails).

Asset classes & inflation behavior (big picture)

  • Equities: Tend to beat inflation over long horizons via earnings growth; short-term sensitivity varies by sector.
  • Inflation-linked bonds: Principal/coupons adjust with CPI; helpful for liability matching.
  • Nominal bonds: Vulnerable when inflation/yields rise; better when disinflation anchors rates.
  • Cash: Loses purchasing power in persistent inflation; good for liquidity, not long-term growth.
  • Real assets (property/commodities): Mixed; can hedge in some regimes but carry idiosyncratic risks.

Worked examples (toy numbers)

Example 1: real CAGR

₹10 lakh grows to ₹18 lakh in 7 years → nominal CAGR = (18/10)^(1/7) − 1 ≈ 8.1%. If average inflation was 5%, real CAGR = ((1.081)/(1.05)) − 1 ≈ 2.95%.

Example 2: retirement income indexation

Target ₹12 lakh in today’s terms. With 5% inflation, year-10 nominal spending target = 12 × (1.05)^10 ≈ ₹19.6 lakh. Your plan must fund that, not just ₹12 lakh.

Be careful with “average” inflation

Headline CPI is a basket that may not match your life. Personal inflation can be higher if healthcare, education, or rent dominate your spending. Build scenarios (base/high/low) and stress-test plans.

Practical tools & habits

  • Track real returns: Keep a simple sheet: each year’s nominal return, inflation, and computed real return.
  • Use real discounting: For long-horizon planning, discount cashflows at a real rate (nominal minus inflation).
  • Index spending: If retired, raise last year’s rupee spend by inflation—then apply guardrails after bad markets.
  • Mix assets: Hold growth assets for long-term real return and stabilizers (bonds/cash) for near-term needs.

Pros & cons of thinking in real terms

ProsCons
ClarityAligns money with lifestyle purchasing powerRequires picking an inflation measure
ComparabilityMakes cross-period comparisons fairShort-term returns can look small/depressing
DisciplineEncourages inflation-indexed saving and SWRPersonal inflation may diverge from CPI

Common pitfalls

  • Projecting in nominal only: Leads to under-saving.
  • Ignoring taxes: Real after-tax can be far lower than nominal headlines.
  • Extrapolating recent inflation: Use ranges and scenario tests, not one number forever.
  • Forgetting sequence risk: In retirement, combine real thinking with glide paths and guardrails.

Five-minute checklist

  • My targeted lifestyle (today’s rupees): ₹____ per year.
  • Base/High/Low inflation assumptions: __ / __ / __ %.
  • Real return assumptions (equity/bonds/cash): __ / __ / __ %.
  • Planned real withdrawal rate and guardrails defined?
  • Two-to-three years of spending held in low-volatility assets?

Bottom line

Inflation silently taxes wealth. Anchor your plan to real returns, index expenses, choose tax-efficient vehicles, and balance growth with stability. The goal isn’t to beat a nominal number—it’s to protect and grow purchasing power.