The average life expectancy for females and males in Canada is 84 and 80, respectively.
Many people are living well into their 90’s, resulting in many retirees having to update financial plans for 30, or more, years in retirement.
At the same time that Canadians are having to plan for a longer retirement, we are seeing interest rates near historic lows. The cash balances in many bank accounts are under one per cent.
GICs are around the two per cent mark for durations between one to five years.
The majority of investment-grade corporate bonds are under three per cent.
The government doesn’t sell Canada Premium or Savings bonds any longer as the rates were so low. Government bonds are currently all under 1.5 per cent, even for a thirty-year bond.
The risk with these rates of return is that your capital will be eroded by inflation and income taxes.
Low interest rates and inflation deteriorates the purchasing power of your cash over the years, especially after you factor in income taxes. Within non-registered accounts, interest income is fully taxed and has zero deferral, which makes the “what ends up in your pocket” even worse.
A little lower in this article, I have listed the eight categories of inflation. What I find is that the categories are not all inclusive. One only has to look at the price of real estate in Victoria or Vancouver to realize that price increases are not consistent with the rate of inflation.
What I find dangerous about inflation is that it creeps up on the average investor slowly. Many investors will have significant cash levels sitting in an individual or corporate bank account for a year, or several years. Every year the cash is not invested appropriately, the purchasing value is declining.
When we present a financial plan to clients, it often shows that their estate will have several million dollars. Right away that numbers seems very high. I’m always reminding clients that a dollar in the future is worth less than a dollar today. The value of a dollar erodes every year.
Bank of Canada inflation calculator
The Bank of Canada website has some links to explain inflation.
To illustrate, let’s say I have a client named Barbara who retired in 1985 at the age of 60. At that time she prepared a budget and felt she could live off of $2,000 a month or $24,000 per year. Using the above Bank of Canada inflation calculator, with actual levels of inflation, Barbara would need $51,070 in 2019 to purchase the same things she could purchase in 1985. During that period the average annual rate of inflation, or the decline in the value of Barbara’s money, was 2.25 per cent.
Consumer Price Index
Inflation in Canada is based on the Consumer Price Index (CPI) which has eight categories:
• Household operations, furnishings and equipment
• Clothing and footwear
• Health and personal care
• Recreation, education and reading
• Alcoholic beverages, and tobacco products.
Each of the above categories has a different weighting within the CPI. As a simple illustration, food has a greater weighting over clothing and footwear, because most people spend more on food.
Inflation is targeted at two per cent
One of the mandates of the Bank of Canada is to control inflation. They have a target, which is two per cent, the midpoint of a one to three per cent inflation target range. The Bank of Canada and the federal government are responsible for reviewing this. Monetary policy is the responsibility of the Bank of Canada’s Governing Council. One of the main tools they have to control inflation is adjustments to the policy interest rate to create a stable price environment. The Bank has the ability to raise or lower the overnight rate to adjust inflation. The overnight rate is used as a benchmark by banks to set interest rates on all forms of lending including home mortgages, lines of credit, and loans.
Decline in the value of money
We know that the mandate of the Bank of Canada is to keep inflation around two percent. We also know that keeping funds securely in a lower interest bank account will protect it based on today’s dollars. It does not protect it based on what those dollars will be able to purchase in the future. Each year,investors keep large sums of money sitting in cash, the faster their money is declining value.
We have outlined some scenarios of investors and how we assisted them in protecting themselves from inflation.
Jill: Still in the workforce
Let’s say we have another client, Jill, who in 2014 summarized her annual spending on groceries, gas, and clothing. For the year, Jill’s total expenses totaled $3,176.
In 2019, Jill once again kept track of her annual expenses. She bought roughly the same type and quantity of groceries, put the same amount of litres of gas in her car, and bought similar clothes. This time the total bill came to $3,480.
The change in the price of these goods can be boiled down to inflation.
In 2014, Jill was earning $63,200 annually, and in 2019 her income increased $69,621, slightly ahead of the rate of inflation.
Recommendation: We recommended that Jill invest her excess cash flow. Jill has used this excess cash flow to invest within her Tax Free Savings Account and by purchasing good quality blue chip equities (the returns of which have historically exceeded the rate of inflation).
Bill: Out of the workforce and owns home
Bill states his goal is to retire at age 60. He recently sold his textile business. He has accumulated funds in both a corporate bank account and RRSP accounts. The corporate account funds are largely in cash from the sale of the business. Bill had most of his RRSP accounts in low interest GICs. Bill also has a principal residence valued at $1 million.
With Bill owning his residence, he is already largely protected by inflation. In order for him to potentially live 35 years in retirement, we prepared some recommendations. We explained to Bill that keeping all of his funds in cash does not protect him from inflation. This is one of his biggest risks.
Recommendation: We discussed with Bill that he could reduce the cash and fixed income components and increase the equity component to better protect the capital from inflation.
During the same meeting we discussed the importance of having the funds that he requires in the next 12 TO 24 months set aside in a cash equivalents type investment to ensure that he is not impacted by short term declines in the stock market. The greater the cash flow need an individual has, the greater the portion they should have in cash equivalents. We had mapped out an investment plan for Bill and over time, when equity opportunities presented themselves, we gradually increased the equity component of his portfolio. Bill will receive a higher level of income from the dividends, from the equities he has purchased, than earning interest on his cash balances in a savings account. In addition, the capital growth expected on the equity holdings over time is projected to exceed the rate of inflation.
Charlie: Out of the workforce and has an inheritance
Charlie retired at age 65 in 2016 with a government pension and all of his savings in a simple savings account at the bank. In addition to his government pension, Charlie receives CPP and OAS. Charlie also owns his own house which is inflation protected.
Recently he has been hearing a lot about inflation and is getting worried. We explained to Charlie that his company pension, CPP and OAS are all indexed to the rate of inflation. These parts of his income flow are protected.
A few years ago, Charlie received an inheritance of $700,000. The portion of his financial situation, exposed to inflation, is the $700,000 of inheritance funds that are sitting in the bank. Approximately half of these funds are in a savings account earning one per cent and the other half is invested within two year GICs earning 1.9 per cent. For the last three years, Charlie has lost purchasing power on these funds and has not kept pace with inflation.
Recommendation: We recommended that Charlie invest the portion of his funds that was not locked into GICs into good quality blue chip dividend paying equities. We mapped out a plan that as each GIC came due to gradually increase his allocation to equities and more liquid fixed income options, depending on his cash flow needs.
Sandra: Sold residence and moved into assisted living
Two years ago, Sandra sold her house for $800,000 and moved into an assisted living arrangement. She is 79 years old and did some preliminary planning. The monthly costs when she moved in were $5,800 or $69,600 annually. After two years living in the assisted living residence she realized that only a portion of the residence costs are under rent control increases. The residence has the ability to increase the other costs (i.e. cleaning, food, etc.) that don’t have rent control. Instead of paying $5,800 a month, the costs have already climbed to $6,700 a month after two years.
If Sandra had maintained a principal residence, it would likely have increased in value to keep pace with inflation and cost increases. When the house sold she put the funds into a high-interest savings account earning 1.4 per cent interest. Sandra is starting to get concerned that her funds will not last if prices continue to rise or if she requires greater care in the future.
Recommendation: When me met with Sandra we mapped out a plan put together a balanced portfolio of 40 per cent in cash/fixed income and 60 per cent in equities. All of the equity and fixed income investments would generate either interest income or dividend income.
We discussed with Sandra the importance of setting aside 12 to 24 months of cash flow needs into a cash equivalent or short-term fixed income investment to fund her rent. In Sandra’s case, we set aside $120,600 (18 months x $6,700) into the iShares Core Canadian Short Term Bond Fund which will be used to fund her month costs. We also put $200,000 into the iShares Canadian Corporate Bond Index. With the remaining funds we mapped out a strategy of 30 different dividend paying equities.
In addition to the investments we encouraged Sandra to consider other assisted living arrangements that may be more economical. Sandra was able to put her name down on a waiting list for another residence that will be $4,400 a month. She anticipates being able to move into the new residence within the next year.
Full exposure to inflation risk
Individuals who are most exposed to inflation risk are those who do not receive an indexed work pension, CPP or OAS. People who rent versus owning a principal residence are also exposing themselves to inflation risk. Investors who choose to keep cash in a savings account or in GICs are also generally not keeping pace with inflation.
If the dollar amount of your investments is the same as it was a year ago, you have essentially taken a step backwards. Even if you have invested the assets really conservatively, you can still be losing ground.
We will illustrate this by assuming you are in the 30 per cent tax bracket and inflation is at two per cent. If you started the year (Jan. 1, 2019) with $1,000,000 in a GIC and earned 1.9 per cent interest income of $19,000, after paying $5,700 in income taxes ($19,000 x 30 per cent), the value of your savings on Dec. 31 would be estimated $1,013,300 after taxes accounted for. The December inflation was at 2.2 per cent. If we assume 2 per cent inflation for the year, then $1,020,000 on Dec. 31, 2019 would be equal to a $1,000,000 on Jan. 1, 2019. The investor who purchased the GIC actually had a decline of $6,700 ($1,020,000-$1,013,300) in purchasing power.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director of wealth management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears here every week. Call 250-389-2138. greenardgroup.com