Effects of inflation

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We all know the cost of goods and services rises over time.  Single postage stamps that cost 85 cents just 3 years ago now cost a dollar.  The same thing has happened to virtually everything we purchase.  This is what we call “inflation” – a sustained rise in the cost of goods and services over time.  It also means that the purchasing power of a dollar decreases over time because you need more and more dollars to buy the exact same goods or services.  This has important implications for your savings; especially in your retirement years.

What you need to know

Canada has been in a period of low inflation for the last 20 years, particularly in the last 7 years where we have averaged less than 2% a year.  This is considered low, as both Canadian and U.S. central banks would like to see inflation at the 2% or higher level.

But we haven’t always been in a low inflation environment.  The graph above shows that from 1952 to 1981, inflation was rising, sometimes dramatically into double digits, over this period of time.  So, we should not assume that inflation will remain the same indefinitely.

Currently, most financial planners use a 2.5% to 3% inflation rate for planning purposes.  A 3% inflation environment means an item costing $100 at the beginning of the year will cost $103 by the end of the year.  That item will cost $106.09 by the end of the following year, and cost $134.39 at the end of 10 years.  This is the compounding effect of inflation and it destroys the dollar’s purchasing power.  This means that if you require $60,000 a year now to maintain your lifestyle, it will take $80,634 to do that in 10 years’ time, $93,000 in 15 years, and $145,000 in 30 years, assuming a 3% inflation rate.  This obviously has devastating implications for your retirement savings.

If you keep all your money in savings accounts, bonds, or other “safe” instruments that pay less than the rate of inflation, you will see your savings dwindle faster and faster over time as you draw more and more money out each year to keep up with inflation.  This is why it’s important to invest in assets that have returns which can at least keep up with the rate of inflation, so you can preserve the value of your savings and stem a rapid depletion otherwise.  With our longevity now taking us into our 90’s or even 100’s, having savings that will last longer should be a major consideration.

Bottom Line

Inflation is the insidious enemy of your retirement because it erodes the purchasing power of your money.  If you don’t take inflation into consideration for retirement planning, you are doing yourself a disservice as you may fall far short of your actual retirement income needs in the future.  Consult a financial advisor who understands the impact of inflation and knows how to structure your investment savings to keep you in front of inflation instead of behind it.

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Disclaimer

This information is designed to educate and inform you of financial strategies and products currently available. As each individual’s circumstances differ, it is important to review the suitability of these concepts for your particular needs with a Qualified Financial Advisor.