Inflation has been one of the world’s hottest economic topics in recent years. While most of us understand that inflation means the cost of living is rising, few investors realize that inflation is one of—if not the biggest—risks to their financial plans. Thankfully, there are ways to address the hidden threat of inflation in your retirement strategy.
What is inflation?
We measure inflation through the Consumer Price Index (CPI), which tracks increases in the prices of a fixed basket of goods and services. This basket includes food, shelter, clothing, transportation, and other expenses, providing us with the average increase in price that a typical Canadian might experience over time.
A positive inflation rate means the value of your money is decreasing. For example, if a loaf of bread cost $5 last year and you’ve had a $5 bill in your wallet – that bill is no longer enough to purchase that loaf of bread today. At 3% inflation, the cost has risen to $5.15, and the purchasing power of your $5 bill has decreased. It also means that if, over time, the returns you earn on your investment portfolio are below the inflation rate, you’re losing purchasing power.
But a little bit of inflation can be a good thing. If inflation were negative – known as deflation – the price of goods would get cheaper over time. On the surface, this sounds great. But what incentive would you have to spend your money if that were the case? If you knew that things would be cheaper tomorrow, why buy them today? In that scenario, spending would slow, and economic activity could grind to a halt.
Most developed countries target a small positive inflation rate. The Bank of Canada and the U.S. Federal Reserve aim for a long-term average of 2% per year. That’s enough to spur economic growth while limiting price increases to a manageable level.
Historical and Recent Inflation Rates
The trouble is that precisely maintaining a 2% inflation rate is impossible. Central banks like the Bank of Canada have limited and imperfect tools to control inflation over time. So, inflation rates vary and can remain above or below their target for many years.
Since 1914, Canada’s average annual inflation has been approximately 3%. After remaining relatively low for years, inflation rates rose sharply in 2021, with the yearly average reaching 6.8% in 2022. Monthly inflation peaked at 8.1% in June 2022. There are many causes for this surge, mostly tied to the economic impact of the COVID-19 pandemic. Bringing inflation down has since been the primary goal of central banks globally.
On October 15th, Statistics Canada announced that year-over-year inflation fell to just 1.6% for the 12 months ending in September. While this is a welcome relief, it doesn’t mean that things got cheaper—just that the rate at which prices increased was lower than in the past few years.
How does PWL factor inflation into financial plans?
Financial planning involves making projections. While helpful, projections are usually wrong. We must make educated guesses about unknowable variables like investment returns, future tax rates, and inflation. While we can use history as a guide, we can never be sure what the future holds.
At PWL, we update our inflation projections semi-annually, using a blend of the historical inflation rate since 1900 and the Bank of Canada’s target inflation rate. Currently, we’re using 2.50% in our clients’ financial plans.
Typically, a financial plan includes retirement projections. We make assumptions about those unknown variables, compare your future needs to your present scenario, and make recommendations to ensure you remain on track to meet your short- and long-term goals. We then stress-test those plans using various tools, including simulating a range of possible investment outcomes.
But what many investors—and even some financial advisors—don’t realize is that the inflation rate can have a significant, even catastrophic, impact on a retirement plan.
For example, take the case of a 30-year-old who is saving for retirement.
Let’s make the following assumptions:
Are they on track to save enough to meet their retirement goals?
In this case, yes.
With these assumptions, they’ll have enough to cover their retirement income needs.
The images below show their projected account values and projected retirement income over time:
Notice that their retirement income needs to increase yearly – that’s inflation in action. Their expenses of $60,000 in today’s value increase each year, starting today. By retirement, that $60,000 in today’s dollars balloons to over $140,000 in future dollars, a nearly 250% increase in expenses just to maintain the same standard of living.
By age 95, they’ll need $305,000 in after-tax income to spend the equivalent of $60,000 today.
But what if inflation was higher than expected?
What if inflation was 2.75% instead of 2.50% —just 0.25% more each year?
In that case, we have a problem:
See all that red?
Those are shortfalls in late retirement. Instead of being left with a small estate, this investor runs out of money at age 92. They are over $1 million short of the money they need to fund those last few years.
At 2.75%, their income need at retirement is $150,000, and at age 95, it’s $350,000 annually.
If inflation was significantly higher than projected – say 3.50% annually instead of 2.50% – the situation becomes dire:
They run out of money 13 years early, and the shortfall grows to over $5 million. At retirement, they need $200,000 annually to purchase the same basket of goods that $60,000 buys them today.
By age 95, they need an astonishing $561k per year.
Strategies to Defend Against Inflation
Given that inflation is unpredictable, how can investors defend their retirement plans from inflation shocks?
There are few ways to hedge inflation risk fully. However, both CPP and OAS are fully indexed to inflation. CPP adjusts in January of each year based on the previous year’s inflation rate, and OAS increases quarterly. If inflation is ever negative, CPP and OAS payments are not reduced.
Some Canadians have access to defined benefit pension plans through their employment, many of which are also indexed to inflation. However, these plans often contain clauses that limit the cost of living increases in some way, so they are not always perfectly hedged.
Historically, asset classes like global stocks have provided investors with real returns – meaning investment returns have, over long periods, exceeded the rate of inflation. Most investors track their returns in nominal terms – before adjusting for inflation – but not in real terms. When inflation increases, the real return is diminished unless investment returns increase as well. While nothing is guaranteed, if history is any guide, investing in a diversified portfolio of global stocks should help investors grow their wealth in real terms.
Diversification means owning investments that perform differently from each other. Since we don’t know where investment returns will come from or when, we should aim to own as many investments with long-term positive expected returns as possible. This means owning stocks from many countries, in many sectors, and potentially adding other asset classes like bonds to your portfolio.
Investment returns can’t compensate for inadequate savings habits. Investors should aim to save early and often, take advantage of tax-advantaged retirement accounts like Registered Retirement Savings Plans (RRSPs) and Tax-Free Savings Accounts (TFSAs), and increase their savings contributions as their income grows throughout their careers.
Being flexible with retirement expenses can help retirees by reducing spending in years where investment returns are poor or inflation is high. While not always feasible, maintaining a budget with flexible discretionary expenses can provide a buffer against unexpected financial challenges.
Above all, investors should have a comprehensive financial and retirement plan. That plan should be stress-tested not only for poor or lower-than-expected investment returns but also for higher inflation scenarios. A financial plan is a snapshot in time and should be updated frequently as circumstances change.
Inflation might be unavoidable and unpredictable, but it’s not insurmountable. While Canadians should welcome the recent drop in inflation rates, we’ll likely see periods of higher-than-normal inflation again. Proactive planning and informed investment choices can help safeguard your retirement against inflation and secure a more comfortable financial future.
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