Archive / Investment Adviser (Level 2) / Miscellaneous Aspects of Retirement Planning

nism-series-xb-partial-pension-indexation-purchasing-power-erosion[ INVESTMENT ADVISER (LEVEL 2) ]

Mr. Smart receives an annual pension of Rs. 4,80,000 that adjusts for inflation at only 50% (3% annual increment), while general living expenses escalate at 6% p.a. Over a 20-year period, what happens to the purchasing power of his pension?

[ A ]It remains perfectly constant in real purchasing power terms

[ B ]The pension purchasing power doubles due to compounding interest

[ C ]The pension is automatically increased by the Central Government to match CPI inflation

[ D ]The real purchasing power of the pension progressively degrades, creating an expanding annual cashflow deficit that must be funded from his personal investment corpus[ CORRECT ]

Takeaway

Because the pension grows at only 3% while living expenses grow at 6%, its real purchasing power progressively erodes, creating an expanding annual cashflow deficit that must be funded from the personal corpus, so option D is correct.

Derivation

With expenses compounding at 6% p.a. and the pension compounding at only 3% p.a. (its 50%-indexation formula), the gap between the two widens every year rather than staying flat, since compound divergence accelerates over time. By Year 27, this gap has grown from an initial Rs. 1,00,000 shortfall to over Rs. 17,30,000. This tests whether candidates understand that partial indexation is not a one-time haircut but a structurally worsening problem over a long retirement horizon, requiring an ever-larger draw from the investment corpus each year to bridge the widening gap.

Why the others fail

A — It remains perfectly constant in real purchasing power terms

Purchasing power can only remain constant if the pension is fully indexed (100%) to inflation; a 50%-indexed pension necessarily loses ground over time.

B — The pension purchasing power doubles due to compounding interest

Compounding inflation at 6% outpaces the pension's 3% growth, steadily eroding purchasing power rather than doubling it.

C — The pension is automatically increased by the Central Government to match CPI inflation

Private-sector and fixed-formula pensions adjust only per their contract terms (50% here) and are not automatically topped up by the Central Government to match CPI.