“Inflation” can be a very scary word in Manitobans’ lexicon. Especially if you lived through the hyper-inflationary years of the 70s and 80s! Well “inflation” is making its way back into the headlines as our current economic landscape is driving the cost of living up dramatically (4.4% per year as of September).
What does high inflation mean for your retirement? For your investments? Is there anything you can do to “inflation-proof” your financial plans?
How Does Inflation Impact Your Retirement?
When you’re retired, you’re living off an accumulation of all the assets and benefits you’ve accrued in your working years. Those assets are routinely drawn down upon, ideally to provide a certain after-tax lifestyle. If your retirement lifestyle has suddenly become more expensive because food costs more (+3.9%), transportation costs more (+9.1%) and housing costs more (+4.8%), you may need to make some changes!
The good news? Many benefit programs, like Canada Pension Plan and Old Age Security, routinely enhance their benefits in response to changes in the Consumer Price Index. If your retirement income includes these programs, you likely have some built-in inflationary protection.
How Does Inflation Impact Your Investments?
Generally speaking, higher inflation erodes the real return you receive on your investments. In a world where you earn 5% on your investments and inflation is 2%, you’ve improved your purchasing power by 3%. In a world where you earn 5% on your investments but inflation is 5%? Your real return is effectively 0%!
If you’re a more aggressive investor, with a higher weighting in equities, you’ll likely face minimal investment impacts directly tied to inflation. This is because inflation by itself has little impact on the valuation of equities. In theory, if the cost of goods goes up by X%, then the corporations selling those goods will see their revenue go up by (at least) X% to compensate.
If you’re a more conservative investor, with a higher weighting in fixed income investments, inflation has a very real impact on you. Aside from the reduced purchasing power, inflation tends to equate to higher bond yields and lower bond prices. As central banks raise interest rates, future issues of bonds will deliver a higher yield. However, any existing bonds with comparatively lower yields will see their value decrease as a result. A double-edged sword for harming fixed income investors who are anticipating selling before maturity.
How Should You “Inflation-Proof” Your Plans?
For starters, revisit your retirement plan and adjust your projections for higher inflation. If your existing plans have the wiggle room to sustain long-term, higher-than-average inflation, then there’s nothing to worry about! If they can’t, you may need to consider making some adjustments to your lifestyle, retirement deadline, savings rate, portfolio construction, or any other variable that you feel comfortable changing.
As far as investment portfolios go, review your fixed income holdings for inflationary risk. Your investment advisor should be able to give some recommendations for enhancing real returns and/or reducing risk in our current environment.
The moral of the story? Inflation is very uncomfortable and very noticeable when you’re at the checkout counter in the grocery store or paying at the gas pump. But it doesn’t have to ruin the next 20, 30 or 40 years of your retirement plan!
The Central Bank of Canada is expected to keep a very close eye on inflation and take swift action to keep it contained. Hopefully “inflation” in the news cycle is very short-lived this time around.
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