Why inflation numbers can be misleading

Advisors are preparing clients for more expensive retirements. Assuming annual inflation of 5%, a retirement income of $50,000 must translate into $170,000 in 25 years just to stay even. This means that income must triple in retirement. When the newspapers say that we are living in a low-inflation world, why would anyone use a 5% rate in their planning?

Well, in September, the Bank of Canada (BoC) reported the core CPI inflation was up 2.1%, which is just above the mid-point target. This is also known as core inflation, and is the BoC’s preferred measurement. However, this core inflation excludes the most volatile components of the CPI, such as:

• fruit and vegetables;
• gasoline, natural gas and fuel oil;
• tobacco;
• mortgage interest; and
• inner-city transportation.

That same report also said that, compared to the year before, the cost of certain items had risen. Household items were up 4.4%, communications services (e.g., telephone, Internet access) 8.9%, gasoline 6.6%, and natural gas a whopping 26%.

While the BoC says core CPI is the most relevant measure of the cost of living for Canadians, it really only measures the underlying trend of inflation. And, in the current economic climate, we aren’t likely to see inflation reported higher than 2%, even when our daily costs rise faster than that. Here’s why.

Core inflation is misleading

Textbook monetary theory holds that increasing money supply will lead to higher inflation. But according to BusinessWeek, since the U.S. Federal Reserve began QE in 2008, the result has been a 46% increase in the money supply (as of January 2014).

This means the Fed has nearly tripled the supply of money without a corresponding surge in inflation. Yet, with interest rates at historically low levels and the economy still struggling, the normal money multiplier process has broken down, and inflation pressures remain subdued—for now.The formula for inflation is money supply multiplied by velocity (the speed at which money passes from one holder to the next). In the global financial crisis, velocity got stopped in its tracks. Central bankers tried to resuscitate it by sharp, historic increases in money supply. Also, massive stimulus packages were launched to increase velocity. So why hasn’t inflation been higher?

Incorrect forecasts

Tax brackets are indexed to inflation, and it’s in the government’s interest to have them rise as slowly as possible. This way, wage inflation means jumping into a higher bracket sooner. Similarly, cost of living adjustments to public-sector wages, pensions and other amounts are also indexed to inflation, and cost the government more when inflation is higher.

And when people don’t account for rising prices in projections, the greatest risk to retirement savings becomes not a stock-market crash, but their debit card. In other words, the real risk is not when they’ll run out of money, it’s that the money they have will not buy them what their lifestyle ultimately costs. The focus for advisors, then, should not be capital preservation, but income and lifestyle preservation.

The key is to identify what clients realistically believe their lifestyle will cost throughout their retirement, not just at the beginning of retirement. Also, note that the shape of retirement income is likely not a straight line. If we assume a 30-year retirement, help clients find 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 is essential that all retirement income planning be done with the assumption that most lifestyle costs will rise for the balance of the client’s life.

The portfolio must change to address this risk, too. Traditional wisdom is to increase allocation to bonds and other fixed income securities during retirement in order to reduce the risk of capital loss. That was true when interest rates were stable in the 1950s, and fell during the ’80s, ’90s and ’00s. But it’s not true today. Indeed, that advice may be lethal for the next generation of retirees. So, advisors should consider heavier allocations to equities while taking into account their clients risk tolerance.

The greatest financial threat to retirement today is inflation and the erosion of purchasing power. That erosion is insidious, and it’s not being reported in a way where we can properly assess the risks. Moreover, central bankers and policymakers have been courting inflation since the global financial crisis, thanks to TARP, QE and monetary stimulus.

Another side to inflation and erosion of purchasing power is that companies do not like to raise prices, since that 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.

Even though central banks are tapering, I suspect rates will stay lower for longer than anyone anticipated. So inflation is our most dangerous enemy precisely because it appears to be sleeping.

In our retirement projections, we use an inflation forecast at least 1% higher than the core CPI. Our investment strategies focus on producing rising income, often through growing dividends and increasing rents, rather than chasing a fixed yield and protecting current capital value. This is the only way to prepare clients effectively for the lifestyle they want to have in 2035—not 2015.

by Darren Coleman, PFP, CFP, FCSI, portfolio manager with Coleman Wealth of Raymond James Ltd. in Toronto. The views of the author do not necessarily reflect those of Raymond James.