November 18, 2010
In this guest column, York University professor Moshe Milevsky looks at how looming inflation or deflation may affect your retirement.
One the big debates this year has been whether the future holds inflation or deflation. In the U.S., the Federal Reserve is buying bonds which is essentially printing money to push interest rates down and help stimulate spending and growth, leading to worries about inflation down the road. In some European countries, prices are falling despite record low rates, leading some to predict a period of falling prices.
The question we’re all asking, is which is better and what can we do about it.
Deflation is one of those things that sounds good, but as you dig deeper has downsides, particularly for retirees.
I visited Japan last year where deflation has been part of their economic equation for nearly a decade. In each of the last 10 years, average prices have fallen. In Canada the Consumer Price Index (CPI) has increased by a total 17 per cent in the last eight years since the CPI was rebased. Can you imagine declining prices for goods and services every single year for the last decade? You probably don’t need to save as much for retirement, no?
Japanese live five years longer than Western retirees on average, so at first blush it appears deflation is a good thing for them. If prices fall and income is fixed, you’re better off.
But as I learned, it isn’t quite what it seems. While the Japanese economy as a whole has experienced deflation, for a large segment of the population, and especially retirees, the cost of living has been rising for things like medical care, groceries and other living basics.
Here is the problem: Official inflation is measured by averaging thousands of monthly price changes. Some things go up more than average and some less. I had a statistics professor at York University who used to joke that if you place one hand in scalding hot water and the other in freezing cold water, the average temperature of your hands would be just right. You are also in excruciating pain.
Technically, the falling prices of plasma screen TVs, laptops and cellphones are offsetting the rising cost of groceries, nursing homes, medications and the costs of long-term care. The question for an elderly Japanese is does he or she buy plasma TVs or drugs and long-term care.
The problem has also cropped up in the U.S. U.S. Social Security payments – equivalent to our CPP – are adjusted for inflation. Last year and so far this year, this index did not increase, so retirees didn’t get a raise.
The caused a backlash in nursing homes from Florida to Arizona and so President Barak Obama proposed that every retiree get a $250 check to make-up for the lack of inflation adjustment. Alas, the U.S. Senate voted to nix the plan, calling it a $14 billion bribe to seniors which the country can’t afford.
In Canada, year-over-year inflation as of September 30 was almost 3 per cent in Ontario, while nationally it was 1.9%. I suspect Toronto’s inflation rate is higher than 3 per cent. The bottom line is: Beware of averages.
It might seem that a 1 per cent to 2 per cent difference is small, but even a very small inflation rate can have a big impact on purchasing power over long periods of retirement. The table should give you a sense of what even a 2 per cent can do to your purchasing power over the 25 years of an average retirement and beyond.
If you get $1,000 per month in pension income that is not adjusted each year for inflation, then it will buy you $1000 worth of goods in 25 years assuming no inflation.
But, at 2 per cent for 25 years, which is pretty much what we are getting now, the purchasing power of your $1,000 decays to a mere $610. You go to a store with a cheque that says $1,000 and you can only purchase $610 worth of groceries. Where did the other $390 go? That’s inflation. And, if inflation averages 4 per cent per year, your purchasing power is reduced to almost $375.
Considering the fact that the average length of retirement is 20 years, and a substantial fraction might spend 25 or 30 years in retirement you simply can’t afford to ignore inflation and its quirky calculations.
Ok. So, what should you do about it?
1. Learn the difference – Nominal vs. real
This might be obvious, make sure you understand the difference between nominal and real income. Nominal is the amount in your hand. Real is adjusted for inflation; what it actually buys you.
2. Plan for increased cost of living – inflation or not
Canadians approaching retirement should also budget for ever increasing cost of living, even if the average inflation rate is flat or negative. I am not necessarily saying you will be spending more each year of retirement, just that the things you will be spending on will likely go-up by more than inflation. Remember that even if the gap is 1 per cent between your inflation rate and the population inflation rate it can make a big difference over time.
3. Be proactive invest for Real
Finally, be proactive. Your investments should produce real, tangible income returns. This would include commercial and residential property, stocks, and anything else that is a part of the real economy. These assets do not promise a smooth and bumpy-free ride, but at least you’re headed in the right direction.
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Moshe A. Milevsky is a professor at York University. His latest book is Pensionize Your Nest Egg