Impact of inflation on your retirement plan
Marc André Castonguay, CFP, CIM
May 7, 2022
Should investors worry about inflation impacting their retirement plans?
This time of year, my wife and I discuss our summer vacation plans with our kids. Invariably, they will mention how they hope it doesn’t rain during our vacation. And as always, we will reply that we can’t control the weather, but we will include activities in our vacation plan that can be enjoyed even if it rains.
Inflation, much like the weather, is out of our control. And just like a rainy day can ruin a well-planned activity, inflation, if not considered, can ruin a retirement plan. Simply put, inflation represents an increase in the cost of living. If your income does not increase at the same rate, you effectively lose purchasing power, i.e. you can’t buy as much goods and services as you once did.
For many retirees, the bulk of their retirement income comes from their own retirement savings. Here’s a quick look at how inflation can impact retirement income. Let’s assume Robert, age 65, has a $1 million dollar portfolio from which he wants to withdraw $50,000 annually in today’s dollar. His net annual rate of return is 4% and the annual inflation rate is 2%. Robert will be able to make his inflation-adjusted annual withdrawal for 25 years, by which time his portfolio will be liquidated. If the inflation rate is 3%, his portfolio will last about 22 years and at an inflation rate of 4%, his portfolio will be liquidated in 20 years. This example highlights how inflation can affect the duration of a retirement portfolio. Higher inflation could force Robert to retire later than anticipated.
If Robert wants to keep the retirement period of 25 years at all costs, then he would have to lower his annual withdrawals from $50,000 to approximately $44,800 in today’s dollars if the inflation rate is 3%, and to $40,000 if the inflation rate is 4%. To maintain the $50,000 withdrawal in today’s dollars for 25 years, Robert would have needed $1,116,000 in his portfolio if the annual inflation is 3% and $1,250,000 if inflation is 4%.
For individuals who are years away from retirement, inflation will have an impact on the retirement savings needed to cover the desired withdrawals in retirement. Still using the $50,000 annual withdrawal in today’s dollars, a net annual rate of return of 4% and an inflation rate of 2%, someone who is 10 years away from retirement will need $1,220,000 at the start of retirement to cover 25 years of withdrawals. However, someone who is 30 years from retirement will need $1,812,000. Of course, the latter individual will also have more time to contribute to his retirement savings and earn investment income.
The inflation rates in my examples are considerably less than the latest statistics. In Canada, annual inflation came in at 6.7% last March. The last time we saw inflation hit the 6% mark was in 1991. So, it’s understandable that current inflation is unnerving. However, to put things in perspective, even with these latest high levels, the average total CPI (the inflation measure used in Canada) for the last 20 years is 1.9%. So, when preparing retirement projections over many decades, just like it wouldn’t be prudent to use the 2021 double-digit market return as the expected annual return, it is not suggested to use the current inflation rate for long-term projections. In its latest Projection Assumption Guidelines, FP Canada, a national professional body in financial planning suggests using 2.1% as an inflation rate. One of Canada’s biggest financial institutions expects a long-term inflation rate ranging from 2.0% to 2.5%.
Inflation is one of many elements that has an impact on retirement planning. It is essential to take it into account so you may properly plan for the retirement you desire, just as my family will plan for rainy days on our summer vacation.
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This writing is for general information purposes only and is not intended to provide legal, accounting, tax or personalized financial advice. If you are not sure how to proceed with a request for further information, seek help from a professional. Any opinions expressed are my own and may not necessarily reflect those of Louisbourg Investments.