Inflation potholes are just bumps in the road

By Peter Drake | October 2, 2009 | Last updated on October 2, 2009
6 min read

Inflation can make the road to adequate retirement income a challenging one. Why? Because the traditional retirement portfolio, invested heavily if not exclusively in fixed income, is just that: fixed. The income it produces doesn’t necessarily go up each year to offset rising consumer prices – and rising prices gradually, but inescapably, eat away at the retiree’s purchasing power. Put another way, when prices go up and your clients’ incomes don’t, they wind up buying less.

Of course, some sources of retirement income are adjusted for changes in the rate of inflation. Canada Pension Plan and Quebec Pension Plan payments are indexed on an annual basis to Statistics Canada’s Consumer Price Index, as are Old Age Security payments, though the latter are adjusted on a quarterly basis. Some employer pensions contain provisions for adjustments to account for inflation but these are by no means the norm and in many cases, inflation adjustments are at the discretion of the plan administrators. For most clients, inflation is a risk to their nest eggs that they cannot ignore.

In the past several months there has been a lot of discussion in the press about inflation. The angle they have been pushing is that the very stimulative policies of central banks and governments around the world – the policies aimed at fixing the financial market crisis and getting the economy out of recession – will result in a new bout of high inflation. The short answer to the question of whether we are headed toward a period of pronounced inflation is that if central banks and governments were to continue with their present policies for several more years, there would almost certainly be a big increase in the rate of inflation. Instead, provided they get the timing and techniques right, it’s far more likely that central banks and governments will reverse their current policies sufficiently to prevent inflation from rising.

In the case of central banks, some of the reversal is already happening. They are beginning to withdraw the “liquidity support” (lending money to financial institutions) and “quantitative easing” (purchasing securities, a technique used in the United States and Europe but not in Canada). Late in 2010 or early in 2011, central banks are expected to begin to raise their “policy” interest rates from their current rock-bottom levels, though, at least initially, they are unlikely to raise them quickly or to high levels. The timing for the reversal of government stimulus spending is admittedly a little less certain. The spending programs specifically designed to stimulate economic growth should be finished roughly by the end of next year but the actual timing of these is never as precise as governments intend (and would probably prefer). The execution of policy changes do differ between central banks and governments. The former do the analysis, often talk to their colleagues in other countries, make the decision and execute. Governments are required to get consensus, in their own parties, in the legislature and in Canada, with other levels of government. The process necessarily takes longer and its timing is less predictable.

I don’t wish to leave readers with the impression that there is no risk here. Sports fans, think of it this way, the central bankers can be likened to a team with very talented players and an excellent play book. That is a great start but sports teams need to get out on the field or the ice and execute. I have a good deal of confidence that the execution will be competent but games are won on the playing field not in the locker room.

Annual inflation rates have varied a lot over the past several decades. In the 1970s, the worst decade for inflation since the Second World War, consumer price inflation in Canada averaged 8.1% per year. More recently, helped by the advent of inflation targeting by the Bank of Canada in 1991, and monetary policies specifically aimed at meeting those targets, Canada’s inflation performance has been much improved. In the 1990s and so far in the current decade, inflation averaged 2% per year – right in the middle of the Bank of Canada’s inflation target range of 1 to 3% per year.

Recent inflation statistics have caused some confusion by virtue of the fact that in several recent months, the Consumer Price Indexes for Canada, the United States and Europe have been below their year-earlier levels. This is likely to be temporary, caused largely by the fall in energy prices from their elevated levels of a year ago. Also, it is not the deflation that should cause us concern because most other prices have continued to rise. Over the next several months, these price measures are expected to return to the norm of showing increases from year-earlier levels.

Recent forecasts of inflation in Canada and the United States suggest that we will be looking at less than 2% inflation rates over the next couple of years. For those of you who don’t trust economists’ forecasts, I recommend the U.S. bond market’s view (derived from the difference in yield between conventional 10-year Treasuries and inflation-indexed bonds), which indicates the same thing.

In speaking to groups of investors across the country about inflation and retirement, I’ve become accustomed to receiving the now often-asked question about whether inflation rates for people in retirement are different than for the rest of the population. The short answer is: ‘not very much”, at least in the case of the recent total inflation numbers. It is true that spending patterns may be different for retirees than for others, but by and large, the differences have most often canceled each other out in terms of overall inflation. Statistics Canada conducted a study in 2005 that tracked the differences in inflation for seniors and the rest of the population over the period between January 1992 and February 2004. The study found that for senior households, the average rate of inflation was 1.95% per year, while that for the remaining households in Canada was 1.84% per year. However, there were some important differences for different groups of seniors. Those who were homeowners experienced higher rates of household inflation than those who were renters. And, inflation rates for senior households varied considerably by province with inflation for seniors being noticeably higher in the most westerly provinces and in Ontario than in Quebec and the Atlantic region.

What do you tell your clients about inflation? Let’s deal first with what I think is the most likely scenario – inflation continuing to average around 2% per year. That scenario playing out would be good news, but it doesn’t mean your client can ignore inflation. Fidelity’s research shows that over a 25-year retirement (a typical length for many Canadians), inflation at 2% per year takes out approximately 40% of the purchasing power the retiree had at the start of retirement. Obviously, higher inflation rates erode even more of the retiree’s purchasing power, if not protected against adequately. So even under the most positive assumptions, dealing with inflation needs to play a central role in a client’s retirement income plan.

Some of you will have clients who will not have as much confidence as I do that inflation will be kept under control. Some of them will remember the inflation of the 1970s and other periods when inflation was higher than in recent years. Conversations with those clients may be more difficult. You don’t want your clients to over-protect and lose some of the benefits from a well-rounded retirement income plan; one that includes exposure to asset classes that have the potential to keep pace with or exceed the rate of inflation, such as equities. But you also need to remember, especially if you haven’t personally lived through a period of high inflation, that those who have remember it well.

What this all comes down to is that discussions about inflation are client-centric. By all means, start with the broad picture. But an effective conversation will quickly move to the specific concerns of the specific client. Come to think of it, this applies to almost everything you discuss with your clients.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.

Peter Drake