(This post is a part of the series on Basics of Finance and Investing.)

You have bought a 1-year CD for $10,000 at 5% interest rate. After one year you collect $10,500 - a gain of $500. What is your real gain? This depends on what $10,000 can buy one year later, compared to what it does now.

Inflation, the rate at which the prices of goods and services grow with time, will reduce the purchasing power of your original $10,000 investment after one year. Changes in the consumer price index, or CPI (computed as the average price of consumer items purchased by a typical urban family of four), is the standard measure of inflation .

At the current annual inflation rate of 2.5%, you will pay $10,250 after a year to maintain the purchasing power of $10,000 today. So, in effect, what you really gain is $250 (=$10,500-$10,250). In other words, your real interest rate, which defines the growth of your purchasing power, is 5 - 2.5 = 2.5%. The original 5% is the nominal interest rate, which determines the growth of your asset.

Suppose the real and nominal interest rates are r and R, and i is the inflation rate. If the invested amount is a, then the nominal increase after one year should equal the real increase multiplied by inflation. That is, a(1 + R) = a(1 + r)(1 + i), which gives r = (R - i)/(1 + i). When i is much smaller than 1 (like in our example, where 0.025 << 1), we have the approximate relationship

r = R - i.

This is a formal way to present our example. So, higher the inflation, less is the real gain from a fixed-income type investment. Interest rates offered by both the money market and bond market securities are only nominal rate, which you should keep in mind while estimating your asset growth.

Go on to what determines the real interest rate.

No matter how often they have been talked about, some threats are so creepy they are worth telling again. Inflation is dangerous not only because it damages your retirement savings, it works so quietly that you may not even notice, until after retiring when you begin to dip into your nest egg.

There are two things that make inflation so invisible. First, it reduces the purchasing power of your asset, not its absolute amount. Red flags do not usually go up if there is no actual drop in the asset value. Second, inflation works slow. The longer you invest, the bigger is its bite on your asset. Because things do not move fast, we cannot see it early enough.

Take an example. It is generally suggested that you will need between 70 and 80% of your current paycheck to live as comfortably after retirement. So, if you earn $80,000 a year today, in order to sustain your current lifestyle after retirement, you will spend about $60,000 a year then. (On the good side, your mortgages may be paid off, kids may be out of college so no tuition cost, social security and Medicare benefits will kick in. On the bad side, medical expenses may hit the roof, among other things.)

How does inflation figure in this estimate? It does not. Assuming you have 20 more years to retire, and a fixed yearly 3% inflation during this time, what $60,000 can buy today will cost you $108,370 (=60000×1.03²⁰) then! So, you will in fact need 135% of your current salary to maintain the same buying power after 20 years.

What if you retire after 10 years, instead of 20? At the same 3% rate of inflation, you will need $80,635 a year then, about the same as you earn today. So, the longer the wait, bigger is the impact of inflation. Money Magazine has recently discussed these issues in this article.

The recent Forbes list has some of the most expensive items, whose prices have increased from last year by an average 6%, more than double the CPI (standard measure of inflation). A few of the biggest rises are:

1. Ridgewells Diner (Bethesda, MD) serving 40 people: Now costs $9795 - up 31% from last year.
2. Lenox, Williamsburg Shell pattern silverware, 4-piece place setting for 12: Now costs $6960 - up 28% from last year.
3. Natural Russian sable coat, Maximilian at Bloomingdale’s: Now costs $225,000 - up 18% from last year.
4. Nautor’s Swan 70 sailing yacht: Now costs $4,771,550 - up 17% from last year.
5. American Academy of Facial Plastic and Reconstructive Surgery: Now costs $17,000 - up 17% from last year.
6. Men’s black calf wingtip shoes, custom-mad, John Lobb, London: Now costs $4566 - up 11% from last year.

Not that I am worried about such a list (hey, if I want a boat ride, I’ll get myself a $20 ticket to one of those “sea screamers” down in Florida, rather than pay $4,771,550 for a yacht).

Do you think the ultra-rich will zip up their money-belt now? Hardly so - their earning grows at way more than 6%, whereas our salary barely keeps up with inflation.