Although inflation is expected to remain moderate for the foreseeable future, even a 2% rise per year in prices can have an alarming impact on your clients’ standard of living in retirement, analysts say.

Over 10 years, that 2% increase, which is the Bank of Canada’s target rate of inflation, would reduce purchasing power by about 18%; over 20 years, by 33%; and over 40 years, by 55%. This means clients saving for retirement have to make sure their RRSPs grow sufficiently to provide the purchasing power they’ll need in their twilight years.

For example, an RRSP with $500,000 in assets would generate $30,000 in income a year, assuming a 6% annual return. But if you add in annual average inflation of 2%, for instance, your client would need $1.1 million 40 years from now to have the same purchasing power.

The picture deteriorates quickly if inflation is only a little higher. The same $500,000 RRSP would have to grow to $1.3 million in 40 years if annual inflation turned out to be 2.5%; and to $1.6 million if inflation turned out to be 3%.

“It’s not hard to imagine 2.5% or 3% inflation,” says Gaetan Ruest, director of strategic investment planning with Investors Group Inc. in Winnipeg, “and a financial plan that assumes 2% inflation won’t work with 2.5% or 3%.”

Adrian Mastracci, portfolio manager and president of KCM Wealth Management Inc. in Vancouver, agrees. He runs projections for clients with 2.5%, 3% and 4% annual inflation rates so they could see how the small differences can affect their portfolios.

Both Mastracci’s and Ruest’s clients need to look at personal spending patterns when deciding on the inflation assumption they want to use. The consumer price index measures a broad basket of goods and services, whose price behaviour may not match the spending mix of particular individuals.

For example, clients without a health plan may want to add 0.5-1.0 of a percentage point to their inflation assumption — at least, for the period when they are 80 or older, says Ruest. Health-care costs tend to rise as people age and, in fact, have risen much faster than the CPI. Health-care services costs were 31% higher in September vs seven years earlier, while the CPI was up only 14.7% in that same period.

The cost of long-term care in Vancouver begins at $5,000 a month and can easily go up to $8,000 a month, Mastracci notes. Thus, he suggests that clients get critical illness or LTC insurance.

Mastracci makes another point: he says food prices have been rising much faster in Vancouver than the Canada-wide CPI suggests. He recommends clients consider their personal experience when choosing their inflation assumption.

Another factor, Ruest says, is the sources of all of your client’s retirement income. Some of these sources — Canada Pension Plan, old-age security, many private-sector as well as government pensions — are indexed to inflation. This will help determine how much inflation protection needs to be built into RRSPs.

Other experts feel that as long as inflation is low, clients can use a 2% inflation target rather than going into complicated calculations. These experts don’t believe there is a need to build inflation protection directly into portfolios in this economic environment — as long as there is enough invested in equities to ensure the portfolio grows enough to generate the required income after taking the 2% annual inflation rate into account.

But these analysts admit that there’s the possibility of fast-rising inflation in the aftermath of the recession, given the amount of liquidity central banks have been pouring into the system. Unless this is wrung out quickly when healthy growth resumes, there’s the potential the excess liquidity would spur price increases and, even worse for retirees, strong wage demands.

This could happen if central banks miss the start of strong growth and don’t raise interest rates fast enough. But there’s also the possibility that governments, which have amassed huge debt loads as a result of paying for significant infrastructure stimulus packages, may prefer to see inflation rise, as it would lower the amount of debt they would have to repay in real terms.

Ted Rechtshaffen, president of Toronto-basedTriDelta Financial Partners Inc. , is very concerned about inflation in the medium term: “We could see 10% inflation in three to five years, and you have to take that into account.”

@page_break@Rechtshaffen expects to shift his clients’ portfolios more toward equities, which have growth potential that can offset inflation. But he would also include real-return bonds, preferred shares with reset functions tied to Government of Canada bonds, convertible debentures and corporate bonds rated BBB — all of which have at least some inflation protection.

Equities have the potential to grow faster than inflation, he explains, and prices of lower-rated corporate bonds don’t usually fall as much as AA or government bonds when interest rates start rising because of the potential for upgrades in their ratings.

Rechtshaffen says it’s not yet time to make these moves because preferred shares and corporate bonds with seven to nine years to maturity are yielding 5%-6%. That said, you don’t want to wait too long because those securities will be negatively affected by rising inflation.

Meanwhile, not everyone is enthusiastic about RRBs. They are great in theory, but there aren’t many issues, which can push up the price. As well, they are of long duration, Mastracci explains, and your client doesn’t get paid for the inflation until the bond matures.

James Dutkiewicz, head of Toronto-based CI Investments Inc.’ s Signature Global Advisors income team, is even more negative on RRBs. He suggests they were never intended for retail investors; rather, they were targeted toward institutions, which hold long bonds to offset their long-term liabilities.

Mastracci prefers a laddered approach of five, seven or 10 years on the fixed-income side, which smooths out the returns.

Andy MacLean, director of private client strategy with Richard-son GMP Ltd. in Toronto, also suggests a bond ladder with an average duration of considerably less than five years for clients who are concerned about inflation.

If your clients do go for RRBs, MacLean, Ruest and Rechtshaffen suggest balancing them with short-term bonds or guaranteed investment certificates to offset their long duration.

On the equities side, Mastracci recommends large-cap stocks that pay dividends when your clients are close to or in retirement and need stable and rising cash flow. When saving for retirement, he suggests a mix of value and growth investments to get the needed appreciation. He adds that you’ll want a mix because it’s not known which investment style will do best in any particular period.

Although many experts recommend hard assets such as gold, energy, base metals and real estate as natural inflation hedges, Dutkiewicz cautions that unless these investments provide cash flow, they have to appreciate more than dividend-producing equities to provide a good inflation hedge.

The best equities for hedging inflation are those of companies that can easily pass on increased costs to their customers, say Dutkiewicz and MacLean. These include consumer staples as well as regulated utilities. Companies that can’t pass on costs include those facing significant competition and those in sectors in which new technology and product development tend to drive prices down.

In terms of geographical diversification, Canadian equities can do better than U.S. equities when inflation is on the rise because so many of our stocks are resources-based and, thus, have a natural inflation hedge, says Karen Bleasby, senior vice president for investments with Mackenzie Financial Corp. in Toronto.

That said, she does not recommend having Canadian equities only, unless clients are really worried about inflation: “It’s best to have both Canadian and foreign, with foreign accounting for about half” — because of both the geographical and the sector diversification this provides. IE