This year inflation has reached nearly a 20-year high. The most recent inflation figure for August 2021, was 4.1 per cent. For reference, the last time inflation was at these levels was in 2003 when inflation hit 4.7 per cent. The Bank of Canada aims to keep inflation at two per cent, within a control range of one per cent on either side (i.e., as low as one per cent and as high as three per cent).
The biggest tool central banks use to reduce inflation is to increase interest rates. With economies still being fragile, and central banks providing stimulus, they have not used this tool. Instead, they have let inflation go outside of the typical band of one to three per cent.
With inflation rising, what does that mean for you and me? It means that your money does not go as far or buy you as much as it did a year ago, or even a month ago. The best way to show this question is to illustrate it with the Consumer Price Index (CPI). The Bank of Canada measures inflation using the CPI, which has the following nine categories:
• food—groceries and restaurant meals
• shelter—rent and mortgage costs, insurance, repairs and maintenance, taxes, utilities
• transportation—vehicles, gasoline, car insurance, repairs and maintenance, public transit costs
• household expenses—phones, internet, childcare, cleaning supplies
• furniture and appliances
• apparel—clothing, footwear, jewellery, dry cleaning
• medical and personal care—prescriptions, dental care, eye care, haircuts, toiletries
• sports, travel, education, and leisure
• alcohol, tobacco, and recreational cannabis
Each of the above categories has a different weighting within the CPI. As a simple illustration, food and shelter have a greater weighting over clothing and footwear because most people spend more on food and shelter.
Let’s say in 2016 that Jillian goes shopping for the day. She picks up groceries, fills her car up with gas, gets a haircut, and buys a new pair of shoes. The entire shopping experience cost her $574.
In 2021 she went out and bought the identical groceries, put the same amount of gas in her car’s tank, got another haircut, and bought another pair of shoes. This time Jillian’s total bill came to $626.
During this period, the price of Jillian’s basket of goods increased by nine per cent [($626 – $574) / $574]. The change in the price of these goods can be boiled down to inflation.
In 2016, Jillian was earning $74,500 annually, in order to retain her purchasing power, her salary would also have had to increase by nine per cent. If Jillian’s 2021 income is expected to be $81,198, her purchasing power will remain the same; however, if her expected income is anything less than $81,198, it would result in her purchasing power being eroded.
Jack retired at age 65 in 2016 with a government pension and all his savings in a simple savings account at the bank. Overall, inflation has been relatively low since he retired. Recently, he has been hearing a lot about inflation and is getting worried. Jack came to see us in 2021 and we explained CPI and how it is used to index his company pension, CPP and OAS. These parts of his income flow are protected. The portion of his financial situation, exposed to inflation, is the $1,000,000 he has in the bank earning little to no interest.
As shown in Illustration One, the $1,000,000 Jack initially retired with in 2016 would now have to be worth $1,089,905 today in order for him to have kept up with inflation. Assuming he was earning an average of two per cent interest, let’s see how much Jack would have in 2021.
The first step is to determine the after-tax rate of return. Assuming Jack is in the 40 per cent tax bracket, his after-tax interest rate is effectively 1.20 per cent [ 2 per cent x (1 – 40 per cent) ].
Year Opening bank account balance After-tax interest rate After-tax interest earned Ending bank account balance
2016 1,000,000 1.20% 12,000 1,012,000
2017 1,012,000 1.20% 12,144 1,024,144
2018 1,024,144 1.20% 12,290 1,036,434
2019 1,036,434 1.20% 12,437 1,048,871
2020 1,048,871 1.20% 12,586 1,061,457
From the above calculations, Jack started 2021 with $1,061,457 in his bank account, which is $28,448 less than he needs today to have maintained the same level of purchasing power ($28,448 = $1,089,905 - $1,061,457).
In our opinion we do not feel Jack’s savings account, or GICs, are the best option for him over the short-term, or long-term. If costs rise significantly in the future, the amount Jack has in the bank will purchase even less than what it could purchase now.
What can you do to maintain your purchasing power?
Following on with Illustration Two, an option Jack has is to look at investments that may better protect him against rising costs, by taking on a little more risk. There are two ways to look at risk in this context. With Jack’s current situation, he is taking on risk every day as he continuously loses his purchasing power over time.
While investing in the stock market inherently has its own risks, there are many factors to manage these risks with your Portfolio Manager by determining an appropriate asset mix, optimal number of holdings and position size, ensuring appropriate diversification to manage concentration risk, and taking a disciplined approach to rebalancing. Another key concept to managing risk relates to your time horizon for investing. If you have a medium- to long-term time horizon and don’t need to withdraw any funds from your portfolio, then you can weather market downturns. If you have a short-term time horizon, then time horizon can be managed by creating a wedge, which is 12 to 18 months of cash flow needs set aside in a cash equivalent or short-term fixed income vehicle. Or, if a client has a big purchase coming up such as a vacation property, or recreational vehicle, the sooner we know about the purchase the sooner we can begin planning and managing for it. This way, we are not forced to sell an equity at the wrong point in a market cycle.
Although everyone is impacted by inflation and it’s impossible to avoid, by having a solid investment strategy and Total Wealth Plan you can protect yourself against the effects of inflation to ensure that you can maintain your purchasing power and standard of living throughout your life. While it is critical for retirees to maintain their purchasing power since they are past their earning years, we find that it is also important to place emphasis on maintaining your purchasing power during your earning years while saving for retirement. It’s never too early to start planning for and investing in your retirement. The sooner you begin and can guard yourself and your savings against inflation the sooner you will reach your goals.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week in the TC. Call 250.389.2138, email firstname.lastname@example.org or visit greenardgroup.com/secondopinion