Inflation is defined as a generalized increase in the cost of goods and services. To measure it, we usually use the Consumer Price Index (CPI). Inflation risk is the risk that the increase in the cost of living will reduce your purchasing power in retirement.
When you start to use the amounts you invested for your retirement, you will face some uncertainties. Before, you were an employee and you received your paycheck every two weeks or each week, knowing you would always have income and possibly an increase in your salary to counter inflation. In retirement, you have various sources of income, however, probably only a portion of that retirement income is protected against the inflation risk: pensions paid under the Québec Pension Plan (QPP) and pensions paid by the federal government, that is, the Old Age Security (OAS) pension and the Guaranteed Income Supplement (GIS). These pensions are paid for life and are indexed according to the Consumer Price Index (CPI), which means they are not subject to the inflation risk. However, given that the other retirement incomes, such as the income from your personal investments, are not indexed, they are vulnerable to the inflation risk.
You must therefore act with prudence and plan adequately for the withdrawal of your retirement income, both private and public. A good withdrawal strategy is the key to managing 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 valueSee 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
|Current net value|
(Indexation of 2%, interest rate of 4% and a duration of the payment of the pension of 30 years )
|Indexed pension||$280 000|
|Non-indexed pension||$210 000|
|Value of the indexation||$70 000|
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
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.
- Present value: the sum of money which, if invested now at a given rate of compound interest, will accumulate exactly to a specified amount at a specified future date. (Merriam-Webster).)
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