Inflation is a critical factor in personal finance that can significantly affect your purchasing power over time, particularly as you plan for retirement. As prices rise, the same amount of money will buy fewer goods and services in the future. This blog post will explore how inflation impacts your savings and investments and provide strategies to mitigate its effects, including a calculation on how retirees can maintain their retirement income needs over a period of 20 years.
What is Inflation?
Inflation is the rate at which the general level of prices for goods and services rises, eroding purchasing power. Central banks, like the Bank of Canada and the Federal Reserve in the U.S., aim to control inflation to ensure a stable economy. For example, a commonly targeted inflation rate is around 2% to 3%, however, this can vary based on economic conditions.
How Inflation Affects Purchasing Power
- Erosion of Value: Imagine you have $1,000 today. If inflation is 2.5% per year, that $1,000 will only have the purchasing power of about $610 in 20 years. This means you can buy much less with the same amount of money.
- Investment Returns: While some investments can keep pace with inflation, like stocks and well diversified mutual funds, others such as traditional savings accounts or GICs, offer low returns that often do not keep up with inflation rates. This discrepancy can lead to a decrease in the real value of your savings over time.
Retirement Income Needs and Inflation Implications
For many clients, ensuring sufficient retirement income is a primary concern. Let’s consider a calculated example:
Suppose you plan to maintain a retirement income of $60,000 per year in today’s dollars. How much will you need in 20 years, assuming a 2.5% annual inflation rate?
In 20 years, you would need approximately $98,316.99 per year to maintain the same purchasing power as $60,000 today, assuming a 2.5% inflation rate. This illustrates the importance of considering inflation in your financial strategies, and why working with an advisor to tailor an individual plan is vital.
Impact on Pensions
For retirees relying on a company pension that is not indexed for inflation, the situation can be particularly concerning. Even if the pension meets your needs during the first few years of retirement, inflation will gradually erode the purchasing power of those monthly pension payments. This erosion can lead to a scenario where you may not have enough to cover your living expenses later in life. Early financial planning and individual savings & investments is crucial to ensure that your company pension plan can be supplemented by your own investments in the later years of retirement.
Strategies to Mitigate Inflation’s Effects
As inflation can dramatically impact your savings and retirement plans, consider these strategies:
- Invest in Equity-based Mutual Funds: Historically, equities (stocks) have provided real returns that outpace inflation over the long term. Maintaining a diversified portfolio with equity investments can be beneficial. Additionally, professional portfolio managers have a thorough understanding of inflation and its economic effects, allowing them to strategically invest in companies that are deemed ‘inflation-resistant’ during tough economic times.
- Don’t Keep Excess Cash
Particularly during uncertain times, many investors hold more cash than necessary for emergencies (three to six months of living expenses). If you have a major purchase planned within the next three years, holding cash may be fine. Otherwise, excess cash can lead to a loss of purchasing power over time. - Increase Contributions: Consider increasing your retirement contributions over time, especially when you get an annual raise or bonus, to account for the increase in the cost of living.
- Delay Retirement: If practical, consider postponing retirement to allow your investments more time to grow, thus offsetting the effects of inflation on your portfolio.
- Don’t Dip Into Retirement Savings Early: Early withdrawals can deplete your savings and hinder growth potential, making it more challenging to maintain your desired lifestyle in later years.
- Review and Adjust Your Plan Regularly: Conducting regular reviews of your financial plan with your advisor can help you adjust your strategies based on changing inflation rates and personal circumstances.
Conclusion
Inflation is a powerful force that can diminish your purchasing power and impact your long-term financial goals. Navigating the complexities of inflation and its impact on your financial future can be challenging. This is where having a financial planner you trust becomes invaluable. We can help you analyze your current situation, project your future needs, and devise a robust strategy to ensure your investments are growing in a way that offsets the effects of inflation. We provide personalized guidance tailored to your unique financial goals and help you make informed decisions.
The comments contained herein are a general discussion of certain issues intended as general information only and should not be relied upon as tax or legal advice. Please obtain independent professional advice, in the context of your particular circumstances. This blog was prepared by Amanda Ashwood, for the benefit of Amanda Ashwood, Financial Planner with Crawford Ashwood Financial, a registered trade name with Investia Financial Services Inc., and does not necessarily reflect the opinion of Investia Financial Services Inc. The information contained in this blog comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability.
The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any securities. Mutual Funds are offered through Investia Financial Services Inc. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the Fund Fact sheet or prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.