Inflation’s impact on retirement savings

Inflation is a big worry for most people heading into retirement, and for good reason: it eats away at the purchasing power of your savings.

But the problem’s worse than you may realize. One of the Bank of Canada’s preferred measures of inflation (“Core Inflation”) takes the Consumer Price Index (CPI) and strips out some of its more volatile components. These include fruits and vegetables, gasoline, natural gas and fuel oil, mortgage interest and inner-city transportation.

See the problem? These are day-to-day staples, and their levels of inflation could be significantly higher than the Core Inflation figure.

So, when your advisor factors inflation into projections of how much you can spend in retirement, and for how long, he or she should use figures that exceed the Bank of Canada’s Core Inflation forecasts.

There’s another side to inflation you need to be aware of. Companies don’t like raising prices because it can hurt sales. Instead, they maintain profit margins by changing packaging so they sell less product for the same price (e.g., less volume in a box), or by swapping higher-cost ingredients for lower-cost ones.

It’s more difficult to see this kind of creeping inflation, but it’s there. In a service economy like ours, wage inflation is even more dangerous. The cost for the chiropractor, dentist and hairdresser becomes slightly more expensive every year.

Spending needs change

The key is to identify what you believe your lifestyle will cost throughout retirement—not just at the beginning. If we assume a 30-year retirement, you and your advisor need to answer to questions such as, “How will the first 10 years be different from the last 10 years?” And “What is the increase in cost of those expenses?”

Cruises may be getting cheaper, but nursing homes certainly are not. It’s essential that all retirement income planning be done with the assumption that most lifestyle costs will rise for the balance of your life.

Your portfolio must change to address this risk. Traditional wisdom is to increase allocation to bonds and other fixed-income securities during retirement to reduce the risk of losses to your initial capital. That may have worked when interest rates were 8% or 9%, but it’s not true today.

So, your advisor may need to recommend a heavier allocation to equities, provided it’s feasible given your risk profile.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.