With the current economic landscape, inflation has become a real concern. Governments and central banks continue to print money and run deficits but claim that all is good. You are starting to see inflation gain traction in the media as well. This media attention will likely continue to increase.
Inflation can have a large impact on more than just how much a hotdog costs at your local sporting venue. When higher than average inflation is sustained it can greatly impact the security of your retirement income. That is precisely what we want to look at today.
Retirement Income
There are three general sources for retirement income in Canada: personal savings, work pensions, and government benefits. The most widely applicable retirement income in Canada is government benefits (Canada Pension Plan and Old Age Security).
The second most common source of retirement income is personal savings. This can come in the way of RRSP/RRIF, TFSA, and Non-Registered investments.
Lastly, some people will also have work pensions. Work pensions come in many different formats; RPPs (DCPP, and DBPP), RCAs, IPPs, PRPPs.
Each source has its own set of pros and cons. However, one similarity that they all share is a sensitivity to inflation.
Inflation
Inflation is a topic we have talked about a lot. This probably won’t change in the near future with inflation currently being one of the biggest economic concerns. In short, inflation is defined as the declining purchasing power of a currency over time. Another way to look at it is the gradual increase in the price of goods and services relative to a currency.
If your income does not increase in harmony with inflation, you will be able to buy less and less as time goes on. During a working career, employees will often get raises, look for new higher paying jobs, or even take on additional employment. However, in retirement that can become a lot more difficult.
In retirement, it is a lot harder to grow your income. Sure you could take on a part-time job, but do you really want to do that? Or, you could draw down your personal savings a little faster. However, this will jeopardize income in later years.
Inflation & Retirement Income
Government benefits (CPP and OAS), have inflation protection built-in. Benefit payments are reviewed regularly and are increased to cover inflation. If inflation is reported at 2%, government benefits will increase by 2%. For many, this is not the only source of retirement income.
Most pensions will have some inflation protection built-in. Many will increase by 75% of reported inflation. If inflation is reported at 2%, then your pension benefits will increase by 1.5%. They also will often have a cap that says benefits can not rise by more than a certain amount in any given year.
Your personal savings do not have structured inflation protection. However, there are investments you can own that will hedge against inflation. Furthermore, if the economy is inflating, that inflation will also generally be reciprocated in the price of the hard assets you’re holding.
Where The Issue Lies
For many people, government benefits are not sufficient to cover retirement expenses. If they are lucky enough to have a work pension, the pension increase usually won’t mirror the rise in inflation exactly.
Inflation is also a lagging indictor. This means that price increases are felt before inflation is actually reported. So your increase in pension income will only come after your have already paid the higher price.
The scariest part of it all is the implications of what happens if we have extreme inflation or if inflation is not fully reported. Like we mentioned earlier, many pensions have a cap on the allowable annual increase. That might be 2%. So what happens if we have multiple years of 5%+ inflation? Well, the purchasing power of your pension evaporates even more rapidly.
The same thing happens if inflation is underreported. If inflation is really 4% and it gets reported at 1.5%, the purchasing power will also decrease significantly. If you do not believe that inflation can be or has been under-reported check out the following posts:
- The Ongoing Inflation Facade
- Inflation is Higher Than You Think
- Are the Posted Inflation Rate a Lie?
Conclusion
Although the government(s) and central bank(s) want you to believe that all is good and there is no need for concern, this might not be the case. Higher inflation is a real prospect. If high inflation does hit, governments will do whatever they can to try and minimize the reality of it. They will change a formula (like they have with CPI), or they’ll find a new way to ensure real inflation isn’t reported. When that happens, we as the general public will be the ones to feel that burden as our purchasing power and retirement income begin to deteriorate quicker than we are used to.
This article was published by Forbeswealth on May 7, 2021
