Here's what rising inflation means for your retirement
As the one-year inflation rate reached 5.7 percent in February, higher prices have become top of mind for Canadians.
This is the most significant annual increase since August 1991, when inflation was 6%.
There are far-reaching consequences for workers and retirees in terms of how they budget, invest, and plan for retirement.
Who will bear the brunt of the rate increase?
Inflation has averaged 1.9 percent over the last 30 years.
In 1991, the Bank of Canada set an inflation target of one to three percent, with the goal of keeping annual inflation between one and three percent, ideally close to the two percent midpoint of that range.
According to the central bank, interest rates are raised or lowered "in order to achieve the target typically within a horizon of six to eight quarters — the time that it usually takes for policy actions to work their way through the economy and have their full effect on inflation."
The most recent deviations from the target have been on the negative side, most notably during the global financial crisis in 2009 and again in 2020 after the onset of the COVID-19 pandemic.
In both cases, prices fell temporarily year on year.
Inflation has now taken hold globally.
Annual inflation in the United States (7.9%), India (6.1%), and the eurozone (5.9%) has been rising, and most African and South American countries have rates above 5%.
As inflationary pressures began to build in 2021, many, most notably the United States Federal Reserve, believed that inflation was transitory or temporary and unlikely to last.
The question now is, what if it does?
According to Statistics Canada, the average hourly wage increased by only 1.8% between 2020 and 2021.
If inflation remains persistently high, workers whose earnings are unable to keep up with the rate of inflation face a pay cut.
Employees should factor this into salary negotiations, and business owners should factor it into pricing and staffing decisions.
Those with a lot of debt may see their cash flow reduced as interest rates rise — the natural central bank response to high inflation.
That decrease in cash flow may not be immediate, but many mortgage borrowers will see their amortisation period lengthen as more of their monthly payments go to interest and their debt-free date is postponed.
This is an important consideration for first-time homebuyers who want to balance their home ownership goals with other priorities such as retirement.
To maintain a 25-year amortisation period, an increase in mortgage rates from 2% to 4% would necessitate a 24% increase in monthly payments.
Maintaining the same monthly payments after an increase from 2% to 4% would extend a 25-year amortisation to over 38 years.
High debt levels, such as those found in Canada, are inherently deflationary, but this may not be enough to counteract the global forces driving up prices.
Moderate, consistent inflation can be beneficial to the economy and stock market investors, which is one of the reasons central banks strive to control inflation through monetary policy.
Stocks can provide an inflation hedge, but there are some caveats.
When higher input costs for businesses are combined with lower sales due to decreased consumer demand, corporate profits and stock prices can suffer.
Higher borrowing costs for heavily indebted companies can have a negative impact on their cash flow, just as they do for heavily indebted consumers.
High inflation can cause stock market volatility and lower real (inflation-adjusted) returns in the short run.
Value stocks have historically outperformed growth stocks during inflationary periods, in part because higher rates can benefit stocks with near-term earnings potential and less debt.
This scenario has recently played out, following more than a decade of outperformance for growth stocks.
Higher interest rates can be negative for bonds in the short term because if a new bond is issued today paying 3% interest, yesterday's 2% interest bond becomes less appealing to investors.
Bonds are traded on the open market in the same way that stocks are, and as a result, they typically fall as interest rates rise.
As a result, during inflationary periods when interest rates are rising, an investor holding bonds, bond mutual funds, or bond exchange traded funds may see a negative return on their fixed-income investments.
The longer a bond's maturity date, the more vulnerable it is to rising interest rates.
Short-term bonds, real return bonds, and rate-reset preferred stock may be less vulnerable.
Higher rates may eventually benefit fixed-income investors who can invest at higher returns.
Keeping cash on hand in the meantime is a two-edged sword.
It can avoid the risk of short-term bond losses, but with a 6% inflation rate, a dollar in the bank today is only worth about 94 cents after a year.
The impact of inflation on a pensioner is determined by the terms of their pension plan.
A retiree with a fixed pension payment is vulnerable to higher inflation, especially if they do not own stocks or real estate, which can act as a hedge against rising prices.
Those who have indexed pensions may be protected from rising prices if their pension keeps up with inflation.
Some pensions only provide partial inflation protection, particularly when inflation exceeds certain thresholds, or annual inflation adjustments may be conditional and based on pension performance.
Pensions under the Canada Pension Plan (CPP) and Old Age Security (OAS) are indexed to inflation and adjusted annually in the case of CPP and quarterly in the case of OAS.
A pensioner can apply for CPP at the age of 60, and for OAS at the age of 65.
Both pensions can be deferred until the age of 70, and each month of deferral results in a higher lifetime pension payment.
There are numerous advantages to deferring these pensions, particularly given that the breakeven age at which a recipient will have collected more lifetime income is much lower than the average senior life expectancy.
However, because the pensions are inflation-indexed, the recent increase in the cost of living highlights a powerful inflation hedge that is available to nearly every Canadian retiree who chooses to defer and increase these pensions.
If an investor had $100,000 earning 4% per year and withdrew 4%, or $4,000, in the first year and increased those withdrawals at 2% inflation for 30 years, they would have approximately $26,000 left after 30 years.
If inflation was 4% per year, and all other variables remained constant, those indexed withdrawals would deplete the account in 25 years.
However, a persistently higher rate of inflation would likely result in a higher long-run return due to higher interest rates and stock market growth.
If the investments returned 6% while maintaining a 2% real (inflation-adjusted) rate of return with inflation at 4%, the investment balance after 30 years would be approximately $44,000.
Higher inflation is concerning in the short run and can cause uncertainty.
To offset rising living costs, the Bank of Canada is likely to keep raising interest rates.
There is a risk that rate increases have taken too long to begin, or that they are now occurring more quickly than expected, which could have consequences for savers, retirees, the economy, and the stock market.
Although we have grown accustomed to relatively low and stable inflation in Canada over the last 30 years, higher inflation both at home and abroad is now on everyone's radar.
Although "transitory" inflation is unlikely to become a long-term, permanent phenomenon, the time horizon and effects are clearly much longer and more widespread than some policymakers anticipated.
There are 0 comments on this post