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Understanding the impacts of inflation and life expectancy

Individuals generally need about 70% of their average gross annual employment income of the past three years to maintain their standard of living in retirement. For an estimate based on your personal situation, you will need to determine what your expenses will be at retirement and take inflation into account. A representative might be able to assist you, and the Calculators - Personal Finance available on our website could be useful.

If your retirement income is not indexed,1 70% of your salary will lose its purchasing power over the years.

What impact will the cost of living have if your retirement is extended?

Let’s take the case of Charles, newly retired at age 60 whose income is now equivalent to 70% of the average salary he earned in the past three years. The table below shows the impact of inflation on the purchasing power. After 20 years, Charles will end up with a retirement income equivalent to 43% of his preretirement salary, assuming a 2.5% annual inflation rate. Even if he receives the same annuity payments, his money will have lost purchasing power due to the rising cost of goods and services over that period.

Number of years
of retirement

Purchasing power

0 (beginning of retirement)

70% of salary

 1 year

68% of salary

 5 years

62% of salary

10 years

55% of salary

20 years

43% of salary

30 years

33% of salary

We are assuming that the annual inflation rate is 2.5% and that Charles’ retirement income is not indexed.1

How many years will Charles spend in retirement?

A 60-year-old Québec male has a 50% chance to reach age 84 (89 for Québec women2). However, Charles mustn’t plan his retirement with an assumption of 24 years of retirement, because there would be a very high risk of depleting his funds. Charles may live to 84, but it is also possible that he will live past that age. In this case, he would have underestimated the income necessary for his retirement.

Be prudent!

Think about the possibility of living to age 91 and even longer. Anticipate the impacts of inflation on your retirement income.

Any solutions?

Plan, save and invest. The following table shows how a $1,000 investment can accumulate with inflation taken into account or not. For example, if you invest $1,000 a year at an annual rate of 5% for 10 years, you will earn $13,207 without taking inflation into account. The amount accumulated after 10 years as indicated on your statement will indeed be $13,207. However, after a 2.5% annual rate of inflation is taken into account, your investment will in fact be equal to $11,445 in today’s dollars.

  Amount accumulated with annual investment of $1,000
(annual return of 5% and annual inflation rate of 2.5%)
Number of years Inflation taken
into account
Inflation not taken
into account
     
5 years $5,378 $5,802
10 years $11,445 $13,207
20 years $26,008 $34,719
30 years $44,539 $69,761

Easy way to take inflation into account

Perhaps you’re already familiar with the rule of 72. It helps you to estimate the number of years necessary for your investment to double simply by dividing 72 by the expected return. For example, if you expect to earn 6% on your investments, it will take about 12 years to double the value of your investment (72 ÷ 6 = 12).

The disadvantage of this rule is that you don’t know what your money will actually be worth in 12 years. There’s a solution to this problem.

Rule of 72+

Do you want to estimate the number of years it will take to double your investment taking inflation into account? Simply divide 72 by the real rate of return. A simple method to estimate this rate is to subtract the inflation rate from the rate of return. For example, if your investment yields 5% and the inflation rate is 2.5%, your real rate of return is 2.5%. Thus, it will take almost 29 years for your investment to double taking inflation into account (72÷2.5=28.8).

These rules are approximate. The margin of error is usually very low (less than 5% of the number of years to double an investment). For example, if the rule of 72+ indicates that 29 years are needed to double your investment taking inflation into account, the exact value should stand between 28 and 30 years.

 


1 Indexed: adjusted periodically to take inflation into account

2 Source: Les normes d’hypothèses de projection 2012, Institut québécois de planification financière.