Inflation risk

The challenge for retirees who live largely on their retirement investments, is to obtain a positive real rate of return on their investments to offset inflation. This means that the return on your investments must increase at least at a rate equivalent to the rate of inflation to match the increase in the cost of living. For example, if your have a Guaranteed Investment Certificate (GIC) that pays 3 %, while inflation is 2 %, your actual rate of return is around 1 %. Obviously, since you are getting 1 % more than inflation, the inflation risk is under control.

However, inflation is not always the same from year to year, just like the returns generated by your investments. If you do not want to face a slow decline in your purchasing power as you retire, you will need to reassess your investment strategy every year.

In addition, given that the a person's time horizon and tolerance to risk decreases with age, retirees generally face smaller returns. However, you must keep in mind that your retirement income from your invested amounts should always increase at least at a rate equivalent to the rate of inflation in order for you to maintain your purchasing power.

Illustration of the loss of purchasing power

For example, by retiring at age 65 with an annual income of $12 000, which does not take into account inflation, you would experience a 25 % loss in your purchasing power at age 79 and 50 % at age 98.

Illustration of a loss of purchasing power of income that does not follow inflation

An indexed pension is a pension for which the payment amount increases regularly so that the effects of inflation are offset, such as a pension under the QPP, for example. The present value^{See the note 1} of an indexed pension is obviously higher than the present value for a non‑indexed pension.

Table 1: Value of a pension of $12 000/year, based on indexation

To avoid losing your purchasing power during the next 30 years, you should accumulate almost $70 000 more in order to withdraw an indexed amount of $12 000 each year. If the amounts you have invested are not high enough for you to maintain your purchasing power, it is possible that the amount of money you have decreases over the years.

Therefore, you have two choices:

• plan ahead to have more savings, that is, by investing larger amounts on a regular basis or by increasing the risk level of your investments according to your tolerance to risk
• reduce your standard of living before or during retirement to avoid not having enough income.

However, another interesting solution is available to you so that you can reduce the effects of the inflation risk. You could apply for your retirement pension under the Québec Pension Plan (QPP) at a later time. Each month the payment of your retirement pension under the QPP is postponed increases the amount of your pension and can allow you to better manage the inflation risk. Postponing the payment of your retirement pension under the QPP also reduces other risks, such as the longevity risk or the rate of return risk.

You can retire without applying for your pension under the QPP, but, if you continue to work, it will have beneficial effects on your financial health, because you will be saving for a longer period. Your savings will generate a rate of return for a greater number of years. Overall, you will benefit from both a higher pension amount under the QPP and more savings.

In addition, the indexation of that pension decreases the amount of non-indexed income resulting from your investments and therefore reduces the inflation risk related to retirement.

You could do the same exercise with the Old Age Security pension because it increases by 7.2 % per year when you postpone its payment from age 65 to age 70.

Take the time to explore our CompuPension tool; you could simulate a scenario by using your own data and it will help you to better understand your own inflation risk.