Tuesday, February 19, 2013

The Inflation Risk


What is the inflation risk?
 "Inflation is a rise in the general level of prices of goods and services in an economy over a period of time." — Wikipedia
The inflation risk is the possibility that the value of your retirement income loses part of its purchasing power.

For instance, if the annual rate of inflation is 2.5%, this means that what costs $10.00 this year will cost $10.25 next year. It may not seem like much, but even a modest rate of inflation can affect your lifestyle significantly over time. At this rate, goods and services that are $10.00 today will cost $16.40 in 20 years. That's a 64% increase!

Inflation leads to a reduction in the value of money. If you receive the same income in the future, inflated dollars make all goods more expensive and you need more money to purchase the same goods. It also means that if you want to maintain your lifestyle, you'll need to plan for income that increases each by the rate of inflation.

How we measure inflation

The inflation rate is the year-over-year increase in the total consumer price index (CPI) — the most relevant measure of the cost of living for most Canadians. The CPI measures the cost of a typical basket of goods and services.

There are regional variations: inflation will tend to be higher in urban centers and remote areas, and differs among provinces. Each of us experiences inflation differently, based on our geographical location, demographics and types of expenses incurred. In particular, as we age, we tend to have more health care-related expenses, and these have been increasing at a higher rate. Some estimates have healthcare costs rising 4% in real terms (that is to say, over and above the annual inflation rate).

Past experience

In order to figure what's in store for the future, we can look at the historical rate of inflation.

There were two great spikes in the inflation rate in the twentieth century: World War I and World War II. This is not surprising, as Governments ran record deficits to fund war efforts. Although more modest, there was a third spike in inflation in the late seventies and early eighties, explained by oil-producing countries boosting the price of crude oil plus a combination of poor fiscal and monetary policies.

The consensus among economists is that inflation is a monetary phenomenon: printing money to pay for expenditures devalue the currency, and sellers of goods and services increase their prices to preserve their revenue in real terms.

This chart shows the annual inflation rate in the last 50 years in Canada. The trend line shows a gradual decrease that levels off at around 2% in recent years.


Over the last 20 years, central banks have made it a priority to control inflation and maintain it in a sweet spot and this has been largely successful in industrialized countries.
"The Bank of Canada aims to keep inflation at the 2 per cent midpoint of an inflation-control target range of 1 to 3 per cent." — Bank of Canada
The next chart shows the experience in the last 20 years, with a trend line hovering between 1.5% and 2%. This includes Governments recently running large deficits to save the economy from collapsing after the mortgage-backed securities debacle in 2008.


What can we expect in the future? 

We have become accustomed to a low-inflation environment, and seem to embrace 2% inflation and interest rates hovering at the same level. If Governments continue running high deficits unabated, there's a strong possibility that it will cause inflation to creep up to a higher level and this can have catastrophic effects. What is more likely are periods of high inflation, followed by a reversion to normal levels, with Government and central banks successfully implementing counteracting measures.

Even if inflation targets are met indefiinitely, living expenses will increase. The next two charts show the impact of inflation on a nest egg. An amount of $725,000 earning 5% per year with 2% inflation can sustain withdrawals of $40,000 in real terms (meaning that withdrawals increase by 2% each year) for about 25 years. If inflation turns out instead to be 4% per year on average, withdrawing the same amount in real terms will leave you penniless more than five years earlier.



Managing the inflation risk

What can you do to avoid having your retirement lifestyle trimmed down by inflation?

Most of us will get a portion of our retirement income protected against inflation. The Canada Pension Plan and Old Age Security are inflation-adjusted and this keeps their real values constant. Public service pensions are also tied to a cost-of-living index, typically a portion of the CPI. Private company plans that provide defined benefit pensions usually don't have mandated annual cost-of-living increases. However, they will sometimes have "ad hoc" increases based on the pension fund's fortunes, and this will help keep pace with inflation.

Essential vs. discretionary expenses

One approach to managing inflation risk is to first take care of essential expenses by covering them with lifetime inflation-indexed sources of income. CPP and OAS can go toward essentials, with any gap remaining filled with a reliable source of income. Purchasing an annuity may be ideal as it will continue as long as you live, but systematic withdrawals from assets can also work, as long as you are conservative with your rate of returns expectations and earmark sufficient funds to cover expenses to a high age.

Any other funds not earmarked to meet inflation-indexed essential expenses can then go toward discretionary expenses, such as travel and leisure, which can be fulfilled if funds are available and purchase  affordable.

Periods of retirement

Your lifestyle and activities will vary throughout retirement and this will impact your budget. Initially you may experience higher living expenses while most active, followed by a period with a more sedentary lifestyle, then possibly increased expenses late in life as health-related expenses and long-term care becomes a necessity. This can be taken into account when developing realistic retirement budgets with income goals tailored for each period of retirement.

Planning for inflation

What inflation rate should you use for planning? Inflation cannot be ignored, factor it by planning for a retirement income goal that will increase each year by your expected rate of inflation. You received an annual pay increase to keep pace with inflation during your working years. Now you should continue this by planning for an annual retirement income increase.

Historical inflation rates have been much more consistent than equity returns or even fixed income returns. They are less volatile, so the worst case scenario could be around 4.5% if you assume an expected inflation rate of 2.5%. This won't cover extreme "tail" events such as hyperinflation, but there may not be any remedy against such events other than cutting back on expenses should they occur.

Stress test

Can you withstand higher inflation for a sustained period?

A stress test will show you. You can run your retirement projection and make the numbers work using the expected rate of inflation (e.g. 2.5% inflation), and then run the projection again with a higher rate (e.g. 4.5%). Running the numbers at this higher rate may make you bankrupt earlier than you wish. You can then apply some adaptive spending after a few years, for example by cutting back on discretionary expenses and creating a viable scenario if secular inflation sets in during your retirement.

Indexed annuities

An annuity is a contract with a life insurance company to provide monthly income for life. The purchase price of the annuity contract depends on age, whether a survivor pension is payable upon death to the spouse, and rates of interest.

An indexed annuity is an annuity under which payments increase gradually each year to keep up with inflation. Most Canadian insurance companies do not sell true inflation-indexed annuities, where the increases are based on changes in the CPI. Insurers sell instead annuities that increase each year by a pre-defined percentage, for example 2%.

In any case, the higher the indexing, the less the monthly payout. Having an indexing feature means receiving lower initial payments that increase each year by the set percentage (e.g. 2%). Eventually, the payments catch up and surpass the amount you would have received from a level payment annuity. It can take as much as 10 years to catch up to the level payment and many more years to breakeven. In both cases, you receive the same expected value, but the pattern of payments is different.

Annuities are great, but you turn over your capital in exchange for the guaranteed lifetime income. Pricing can also be an issue: how much income you get for the premium and whether you can achieve the same outcome by investing your funds and keeping your capital.

Investing

Stock returns have done relatively poorly during periods of higher inflation. Inflation causes investors to demand a higher risk premium for stocks, so they're prepared to pay less, and this affects stock prices and investment returns. Chao Wei, a professor of economics at George Washington University, conducted a study on the relationship between stock returns and inflation. He found that there's strong evidence that growth stocks returns have been negatively correlated with inflation. However, value stocks are less affected, because these companies typically have more leverage and inflation reduces the real cost of their fixed-rate debt.

The more cash or cash equivalents you hold, the worse inflation will affect you, because fixed income returns barely exceed the inflation rate, and money market returns can actually make you lose money by paying interest at a rate that is lower than inflation. There is an exception to the fixed income category: real return bonds, which can be purchased at a low fee as an exchange-traded fund.

So stocks are almost a hedge against inflation by default, and keeping a portion invested in equities can help boost your returns while keeping volatility at bay.

Other strategies

If necessary and a possibility, two more strategies can help toward managing the inflation risk: retiring later to save and earn more to "pay" for inflation increases during retirement; and working part-time to lower withdrawals from assets during the early years, leaving more money for future higher withdrawals.


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