Going broke slowly, the true cost of inflation

How much did a chocolate bar cost when you were a child?  

“10 cents” is the answer for me.  At least that’s what the convenience store on the corner of Robson and Thurlow (where I returned bottles that I collected in the neighbourhood) charged.   I even remember that it was only 9 cents if I went to the drug store across the street. It’s amazing how financially savvy an 8-year old can be when it’s about candy. I distinctly remember thinking I could get an extra chocolate bar AND have some money left over if I just walked across the street to the Rexall. 

When I ask this question to seniors, some remember the cost of a bottle of pop when they were a child.  And some a specific type of penny candy, like jaw-breakers.  I guess the fact that most people can answer that question, even though it was half a century or more ago, is a glimpse into what was important to us as children. 

Fast forward to today and a chocolate bar at a convenience store costs a couple of bucks – a 20-fold increase in about 45 years.  That equates to a shocking candy-bar inflation rate of 7% per year, something that we are NOT likely to see again in the near future.  Overall inflation has ranged around 3% and right now, the *Bank of Canada has a mandate to keep it between 1 – 3%.

At 3%, over the course of 30 years of retirement, a person’s income will need to grow around two and a half times for them to be able to maintain the same lifestyle throughout.  Or put another way, someone living on an income of $2,500 per month today will need $6,068 per month 30 years from now in order to maintain the same standard of living.  

A lot of thought goes into making sure that people don’t invest in something that will go broke.  Unfortunately, often little or no thought goes into holding instruments that are guaranteed to lose.  We love our guarantees.  Savings accounts, GICs and term deposits are generally guaranteed by the issuer and in part by the government.  They are guaranteed to pay back the principal, but at current rates they are also guaranteed to lose purchasing power.  It may not seem like it because the nominal value is rising a bit each year. Yet in reality, money in those accounts doesn’t usually keep pace with the cost of living, so what one can buy with it becomes less and less each year.   

As advisors, we differentiate between what we call real returns (inflation adjusted) and nominal returns (not inflation adjusted).  Let’s just assume that inflation is 2% going forward. If we earn 2%, we’ve just broken even.  Our “real return” is 0% as we haven’t really gotten ahead. Sure, we earned 2%, but the cost of living just ate it up. In fact, if we only earn 1% in a GIC, we are actually going broke slowly as each year (even though it looks like we’re getting ahead) our purchasing power is being eroded.

If we earn a 3% nominal return, now we’re getting ahead.  That’s a 1% “real return” (3% nominal return minus 2% inflation).  In the same way, if we can manage to earn a 5% nominal return, then that gives us a “real return” of 3%.  

So, in a very weird and wonderful way, earning a nominal 5% is truly 3 times better than earning 3%. By looking at the real returns (3% and 1%) earning a 3% real rate of return we are getting ahead of inflation 3 times faster than earning 1%.  That’s one of the reasons that we have such a strong tendency to encourage investors to behave in ways that increase their returns, even if it means accepting some measure of volatility. 

Financial planners generally combat inflation in one of two ways.  We make sure that clients hold a sufficient portion of their investments in something that will grow or at least something that has a growing income, like dividend-paying companies.  Or we ensure that clients have so much money that they can easily afford to start eroding their capital immediately and maintain the erosion for at least 30 years in spite of taking out more and more each year.  Usually we do a bit of both.

Think of it like this. If you have $2 million invested in great companies that on average pay a 2% dividend and tend to increase those dividends annually at a rate greater than inflation, then you will be paid $40,000 each year (2% of $2 million). Every year that amount is likely to increase by an amount greater than inflation. If that amount plus pensions is enough for you to live on, then you are likely to have more than you need for the remainder of your life. 

Don’t be tricked into thinking that putting long-term money into a bank account paying less than inflation is “safe” because it’s guaranteed. The guarantee is that you will go broke slowly.

*Source: https://www.bankofcanada.ca/core-functions/monetary-policy/inflation

Arnold Machel, CFP® lives, works and worships in the White Rock/South Surrey area where he attends Gracepoint Community Church.  He is a Certified Financial Planner with IPC Investment Corporation and Visionvest Financial Planning & Services.  Questions and comments can be directed to him at dr.rrsp@visionvest.ca or through his website at www.visionvest.ca.  Please note that all comments are of a general nature and should not be relied upon as individual advice.  The views and opinions expressed in this commentary are those of Arnold Machel and may not necessarily reflect those of IPC Investment Corporation.   While every attempt is made to ensure accuracy, facts and figures are not guaranteed.