No one is worried about inflation taking off these days. High unemployment is expected to keep a lid on wage increases — the usual driver of upward price pressure — until the U.S. and European countries get rid of their deficits and have made a dent in reducing their debt.
But even modest inflation of 1%-3%, the Bank of Canada’s target range, will eat away at clients’ purchasing power in retirement, says David Andrews, director of investment management and research at Richardson GMP Ltd. in Toronto.
Furthermore, there are risks that inflation could be higher in the longer term. Strong growth in some emerging markets is expected to keep pushing up the prices of oil, base metals and food, while governments in industrialized countries may not be able to resist accommodating higher inflation in order to reduce their debt burdens.
The impact of inflation on purchasing power increases over time, so, with people living longer in retirement, the risk of serious potential erosion of purchasing power has increased.
A difference of just one percentage point in average inflation in assumptions when planning can make a big difference over the 25, 30 or even 35 years that financial plans now have to cover. If inflation averages 1% over 25 years, it would cost almost $14,000 to buy the same goods and services that cost $10,000 today. That $14,000 becomes almost $20,000 if inflation is 2%; $27,000 if it’s 3%; $38,000 if it’s 4%; and $53,000 if it’s 5%.
Higher return
Clearly, if inflation is higher, your clients are going to need a higher return. That won’t be a problem if real (after inflation) returns go up along with inflation. If you had been assuming a 5% return and inflation of 2%, you’d need 8% if inflation turns out to average 5%. If that’s achievable, your clients should have no problems.
But getting that extra 3% return may not be easy in a higher-inflation environment.
Interest rates will go up with inflation, increasing the yield on newly purchased bonds. But, at the same time, there will be losses in the value of bonds your clients already own because those bonds will be paying less than newly issued bonds. Furthermore, the principal on the older bond, if held to maturity, will buy significantly less than it would if inflation had stayed lower. Only real-return bonds offer inflation protection, with both the interest paid and the principal adjusted for the increase in the consumer price index.
Higher inflation will also increase company revenue and net income, but these may not go up by as much as inflation. That depends on the pricing power of the company.
Both Andrews and Norman Raschkowan, executive vice president, investments, and chief North American strategist with Mackenzie Financial Corp. in Toronto, say stocks in U.S. and European multinationals that sell globally, have well-known brands and pay increasing dividends are good inflation fighters.
Other possibilities are investments in resources and emerging markets, although both sectors can be volatile. Ideally, Andrews says, these are investments clients buy when prices are low and sell when they are high. He also suggests Canadian banks, which have a long history of rising dividends, as well as investments associated with infrastructure, which tend to keep up with inflation. Both he and Raschkowan note that real estate usually goes up at least in line with inflation, which means that a home is likely to keep its value; clients also can invest in real estate income trusts.
Running projections
To find out how vulnerable your clients are to higher inflation, you need to run projections using various inflation and return assumptions. For example, if a 65-year-old client has $200,000 that needs to generate $20,000 a year in today’s dollars to age 95, that’s doable with an average 5% return and 2% inflation, or a 3% real return. But it is not achievable if the return continues to be 5% but inflation is 3% because the money will run out by age 85.
If inflation is even higher — say, 5% — and the return was 7% (2% in real terms), the money would run out by age 81.
To be protected from loss of purchasing power due to inflation in a 1%-3% inflation environment, Andrews says, your clients need a well-diversified portfolio. That diversification will ensure sufficient exposure to inflation fighters such as multinational companies, resources, emerging markets and RRBs. He suggests 10%-15% in RRBs — purchased when their prices are relatively low, not when headlines are full of inflation concerns.
If you or a client become concerned that inflation is likely to move to higher levels for a sustained period, Andrews suggests selling some cyclical investments and increasing the percentage of inflation fighters in the portfolio by 15%-20%. IE