The Effects of Inflation
The challenge that arises with a retirement budget is that it usually approximates expenses in today’s dollars because no one knows for certain what costs will be in the future. It is clear that someone who wants to retire with an income equivalent of $30,000 in today’s dollars will need much more than that in the future. Keep in mind that inflation doesn’t end on the day we retire. It continues to affect our purchasing power throughout life.
The compromise is estimating how much more everything will cost in the future. In other words, it is estimating inflation. That is one of many reasons why all financial plans are an inexact science. We can look at history and try to draw some conclusions but it is impossible to say how accurate they will be.
Using historical data is one tool you can use when choosing an inflation rate for your financial plan. It’s not perfect but it is far better than ignoring the effects of inflation.
The consumer price index (CPI) measures the cost of a hypothetical basket of goods and services used by the average Canadian. It includes such items as the cost of accommodation, food, clothing, transportation, health care, consumer items and so on.
The year to year change in CPI is how we measure the overall cost of living increase or inflation.
Everyone will have their own unique basket of goods and services so it becomes impossible to measure each unique basket and the price changes within that basket. The compromise is to measure the change in the average basket and allow each individual to estimate whether the change in their basket will differ from the average. The changes in CPI, therefore, are meant to be used as a guideline on which to base your own personal assumptions.
The Statcan website provides a wealth of information on this topic. The average annual rate of inflation over a 20 year time period in Canada is illustrated in the table below.
Over the most recent 20-year time period which ended on December 31, 2012, inflation, as measured by the increase in CPI (consumer price index), increased by approximately 2.00% per year. A look at the table will quickly tell you that a basket of goods that cost $86 in 1993 would cost almost $122 in 2012.
Even with the modest inflation that we have experienced in Canada, our cost of living has increased by over 42% in the past 20 years.
A more complete history of inflation can be seen on the Statcan website at http://www.statcan.gc.ca/tables-tableaux/sum-som/l01/cst01/econ46aeng.htm and it is worth examining closely.
There have been 10-year periods where inflation has averaged over 6% per year. At those rates the cost of living would have risen about 70% in that time period!
Under-estimating inflation can be as critical as over-estimating returns when putting together a retirement plan. The two actually go hand in hand. Using a rate of 2.25% per year is slightly higher than recent history but lower than the average rate over the past 50 years.
A History of Inflation in Canada can be seen on MoneyPages
A word of caution is advised. Poor policy decisions by governments and central banks, combined with unfavourable economic circumstances, can result in much higher inflation than we have recently experienced.
The table below illustrates how an inflation rate of 2.25% would affect a retirement budget. A typical retirement lasts more than 20 years so I have included the budget in today’s dollars, what it would be in the first year of retirement, and what it would be in the twentieth year of retirement. The numbers get very big, very quickly.
Those most susceptible to high inflation are the risk-averse and conservative investors. In an effort to protect their capital or principal, they put their purchasing power at risk. It is important to remember that if rates of return are lower than inflation, the purchasing power of a portfolio declines.
In 2011 the rate of inflation was measured at 2.9% while a one-year GIC purchased at the beginning of the year may have carried a yield of 1.5%. While the investor would have had more money at the end of the year, it would have purchased less. Prices had gone up faster than the value of the investment and purchasing power would have been lost.
Inflation is the silent killer of retirement plans. Every year it eats away at purchasing power and the effects cannot be overstated.