Inflation, at times insidious, is the quiet master of our financial planning. It touches every aspect of your clients’ financial lives, affecting how much it costs to live, borrow, save and invest.
Protecting clients from inflation—even when it’s as low as 2%—means maintaining their purchasing power for years to come. Here’s what you need to know to avoid surprises later.
In light of expected short-term inflation, portfolio managers are making minor changes. “When we find good businesses, we tend to hold them for the long term,” says Cameron Webster, portfolio manager at Mawer in Calgary.
And don’t overload a portfolio with inflation-protected assets, warns Michael Greenberg, vice-president and portfolio manager at Franklin Templeton Solutions.“For us, it feels like an environment to add some exposure to inflation-protected assets, but make sure you still have a diversified portfolio.”
Having said that, Greenberg’s reallocated some government bond exposure to inflation-protected bonds, such as U.S. Treasury inflation-protected securities. Richard Batty, portfolio manager at Invesco in Henley-on-Thames, England, is selling U.S. 10-year SWAP government bonds (yielding 2.4%) and buying Australian 10-year SWAP sovereign bonds (3.09%), which have less inflation risk. “The spread is still quite wide, though it has narrowed in recent years,” he says. He also capitalizes on bond steepener trades in Europe and Japan, saying “a number of places are not pricing in the extent of the [pickup] that’s likely in those economies.” On a balanced portfolio basis, Webster’s adding 10-year Canadian bonds as shorter-term bonds mature. “It’s mainly because cash isn’t going to earn what it used to in an inflationary environment, and bond prices have come in quite a bit, so valuation’s better,” he says.
Some bond exposure could also be reallocated to equities, says Greenberg, because of the current growth environment. De-emphasize bond proxies (utilities, consumer staples, telecom), however, in favour of latent-cyclicals (materials, industrials).
“What worked well over the last couple of years was bond proxy sectors. A lot of people overweighted their portfolios in more defensive, high-dividend-paying sectors,” he says. Now, it’s time to rotate out as yields rise. “They tend to be more interest-rate sensitive.”
To the list of cyclicals set to perform well, Webster adds energy, banks and insurance.
But Webster’s criteria for choosing equities haven’t changed. He looks for businesses with sustainable pricing power, like banks and telecoms: “Those are the ones that earn returns of capital even in an inflationary environment.” His other examples are label maker CCL Industries and Amadeus, an IT provider for travel and tourism.
He’s overweight U.S. equities, but not adding to the position. If inflation results from growth, they’re well-positioned, he says.
Batty owns Japanese equities because valuations are reasonable and Japan’s arguably reflationary policies provide a positive backdrop.
However, “our biases globally are European and Asian equities,” he says, because of continued quantitative easing, earnings recovery and value.
Currencies, swaps and gold
Greenberg continues to favour the U.S. dollar. But if other central banks become less dovish, that favour could be short-lived, with other currencies providing opportunities instead.
On the inflation swap market, Batty says the contrast between priced-in U.S. inflation versus that of the U.K. is “extreme”—with Brexit already priced in for the U.K. but not enough inflation priced in for the U.S. “So we are buying U.S. 10-year inflation and selling U.K. 10-year inflation,” he says.
Greenberg suggests advisors consider buying gold as a defensive asset class if inflation picks up beyond current levels. If central banks don’t raise rates accordingly, “you’ve got real interest rates falling, so the opportunity cost of buying gold is lower, and that brings the price up.”
How inflation affects rates and taxes
Inflation makes interest rates appear deceiving, says Allan Norman, advisor at Atlantis Financial. In the table below, when inflation is 0% and you get 3% on an investment, your after-tax return is higher than if you get a 12% return when inflation is 9% (as it was in the 1980s).
Also note that, as tax brackets increase (from 20% to 30%), real after-tax rates of return decrease. “This is why tax planning and making use of TFSA, RRSP and other tax shelters is so important,” says Norman.
|Real interest rate, or return (after inflation)||3%||3%||3%||3%|
|Nominal return (current rate)||3%||6%||9%||12%|
|Nominal return, after tax (20% tax rate)||2.4%||4.8%||7.2%||9.6%|
|Real return, after tax (20% tax rate)||2.4%||1.8%||1.2%||0.6%|
|Nominal return, after tax (30% tax rate)||2.1%||4.2%||6.3%||8.4%|
|Real return, after tax (30% tax rate)||2.1%||1.2%||0.3%||-0.6%|
Source: Allan Norman
He has added to his infrastructure exposure (utilities, pipelines and telecom), which is correlated with inflation and could receive an additional boost from the Trump administration’s infrastructure spending.
Protect purchasing power
In Canada, the Consumer Price Index indicates changes in prices based on a fixed basket of goods and services, such as shelter, transportation, food, alcohol and tobacco.
Prices for product groups, like food and energy, can swing dramatically on supply and demand, affecting your clients’ disposable incomes.
Although energy prices are expected to rise this year, the increase could be offset by decreases in prices for other goods or services. For instance, in 2016, “food prices on average in Canada were down on a year-over-year basis in October and November,” says Nathan Janzen, an economist at RBC. “And those two monthly declines were the largest since the early 1990s.” And, in January 2017, consumers paid 4% less at grocery stores compared to a year earlier.
Allan Norman, an advisor at Atlantis Financial in Barrie, Ont., keeps price trends in mind when creating a financial plan. Due to lifestyle costs like travel, “people’s own personal inflation rate is often higher than the stated rate,” he says.
He adds: “People don’t easily change their lifestyle unless they’re forced to. What would happen with retirees is they would continue doing what they’re doing, and it would affect the value of the estate.”
The good news is that, at least in retirees’ later years, “spending often does not increase with the rate of inflation,” he says. Seniors rarely have debt, he adds, so they don’t have to deal with rising interest rates. And, even if seniors experience higher medical costs, they are often offset by reduced spending on travel and leisure.
The government keeps your tax bracket indexed to inflation, and rental rates can also be raised yearly. On the positive side, some benefits are indexed, too.
|Item||Inflation indexation notes|
|CRA amounts||Tax bracket thresholds and some income tax and benefit amounts are indexed; CRA’s indexation rate is 1.4% for 2017.|
|Old Age Security (OAS) and Canada Pension Plan (CPP)||CPP is revised once a year based on the consumer price index (CPI); OAS is revised quarterly based on CPI.|
|Pension plans||For the Ontario Teachers’ Pension Plan, indexation is 1.3% for 2017.|
|TFSA limit||Since 2009, the limit has been indexed to inflation, rounded to the nearest $500.|
|Lifetime capital gains exemption||Indexed after 2014.|
|Canada child tax benefit||It will be indexed beginning in 2020.|
|Rental agreements||In Ontario, landlords can increase rents 1.5% for 2017; in B.C., 3.7%.|
|Minimum wage||In Nova Scotia, Saskatchewan and the Yukon, the floor is reviewed annually.|
Those close to retirement—or just retired—are most at risk when it comes to inflation. “The price of goods and services goes up, and they don’t have an income that keeps pace with inflation (assuming they don’t have a fully indexed pension). Now they are forced to withdraw more from their investments than originally planned.”
For younger clients, “inflation is like [being] in a boat floating on a rising tide,” says Norman. Incomes and home values tend to rise as personal debt declines. But, if they have significant debt (e.g., a mortgage), they must ensure they can manage cash flows as rates rise.
And, while portfolio returns may increase with higher inflation, inflation has the opposite effect on clients’ tax-related benefits—especially for those people in higher brackets (see “Inflation-indexed amounts”).
Nathan Parkhouse, advisor at Gravitas Securities in Toronto, notes that property taxes have tended to rise faster than inflation (depending on the home’s market value), making for a potentially large expense for pensioners. He warns that some clients might need additional income, like renting out part of a home, getting a reverse mortgage, or selling and downsizing.
For a reverse mortgage, rising interest rates would affect what’s owed but, for most people, home values are likely to rise along with rates. Another option is a fixed-rate reverse mortgage, which can offer protection against rising rates.
Home decisions are emotional, Parkhouse cautions, so a part-time job, consulting or freelancing might be better options for healthy retirees. “That is probably the most controllable option without making major changes,” he says.
Instead of trying to alter spending, Norman focuses on achieving clients’ required annual rates of return. Parkhouse refers to the four pillars of financial planning: paying yourself first, taking advantage of dollar-cost averaging, having a budget, and investing over the long term in good-quality, dividend-paying equities.
Norman suggests performing stress tests on portfolios to show clients what happens under inflation increases, even with steady 2% inflation. “Numbers get pretty large 20 years down the road,” he says, which surprises many clients.
But the realities of inflation must be faced because people are living longer, says Parkhouse, who uses inflation numbers to show clients the risk of investing too conservatively.
Parkhouse’s final inflation tip: ensure clients save a percentage of raises and bonuses and invest it after getting the payments.
Go long on insurance
Léony deGraaf Hastings, advisor and insurance broker at deGraaf Financial Strategies in Burlington, Ont., factors inflation into her insurance needs analysis for clients.
Inflation isn’t usually a concern for mortgage protection, but it would be a concern for things like income protection, kids’ educations and final expenses.
To beat inflation, clients should take the longest term they can afford.
For term insurance, Hastings suggests term 100. “That’s going to lock in their premiums as of their age and the premium prices as of today,” she says. Further, “term 100 might be a more viable premium than a whole life premium.”
To strike the right balance between coverage and costs, “clients can layer their protection,” she says. For example, the insurance portion to cover a mortgage could be term 10 or 20, while the remaining portion could be term 100. “We can blend the premiums as well as the coverage.”
For whole life policies, cash values should be invested in a dividend fund as opposed to fixed income.
Typically, for disability and long-term care insurance, clients have the option to include an inflation protector rider so that income benefits keep up with inflation, says Hastings. Increases usually follow CPI, but a rider could add almost $2 to monthly premiums per $100 of benefit, depending on a client’s age.
Another way to inflation-proof, for clients with the means, is to buy more insurance coverage than they think they need. Hastings says she meets many seniors with insufficient policies of a few thousand dollars that they bought in their 20s.
“Get clients to think about the potential to afford a little more,” she says, “because $500,000 today isn’t going to be the same 20 years down the road.”