Inflation versus your pension is an unfair fight.
Canada Pension Plan and Old Age Security benefits are indexed to inflation, so you’re protected there. But many workplace pensions aren’t keeping up with today’s unusually large increases in the cost of living. Understanding this flaw is crucial to managing your retirement investments.
Inflation erupted about two years ago and has remained resilient enough that the Bank of Canada still won’t cut interest rates. The bank wants inflation around 2 per cent, while the most recent figures put the Consumer Price Index (CPI) at 3.8 per cent.
In your working years, there’s a decent chance of getting raises that partly or fully offset inflation. The average hourly wage went up 4.8 per cent year-over-year in October, which means pay is more than offsetting the rising cost of living.
Life in retirement is more complicated because, aside from CPP and OAS, there may not be any automatic protection for your income. Retirees without pensions may understand this because they have to be hands-on with their investments. But if you’ve got a pension, it’s easy to be complacent about your retirement savings.
This applies even to defined-benefit pensions, which pay a set retirement benefit based on your salary and years of service. DB plans are the pension world’s gold standard because they pay a guaranteed amount for as long as you live, but they’re weak on inflation protection.
“Less than 15 per cent of private-sector defined-benefit plans have built-in cost-of-living increases in their provisions,” said Ben Ukonga, a principal at pension and HR consultancy Mercer.
An estimated 40 per cent or more of public-sector DB plans have full or partial inflation protection, Mr. Ukonga said. Partial coverage would be in the range of 75 per cent to 80 per cent of the increase in CPI.
If you have a DB plan at work, find out the extent of the cost-of-living adjustments you can expect in retirement. If your pension has no inflation protection, consider building your own inflation hedge. Stocks, notably dividend growth stocks, are a good starting point.
The other main type of workplace pension is the defined-contribution plan, which is similar to the DB plan in that money added by employees is matched by their employer. The difference is that DC plan members have much more responsibility for their pensions.
They must choose from a menu of investment fund options to build their pension, and upon retirement must turn their savings into a flow of income that lasts as long as needed. This is a huge weight to put on retirees, but they do have one advantage: In managing their retirement savings, they take steps to offset inflation.
Unfortunately, DC plan members often make conservative investing choices that undermine the battle against inflation.
Jillian Kennedy, a Mercer partner, has noticed a tendency among DC plan members to lower the risk level in their portfolios near or at retirement by reducing stock market exposure. This can backfire by reducing the ability of their retirement savings to keep up with inflation.
Another trap is putting too much faith in safe investments such as guaranteed investment certificates, which can be an option in DC plans along with equity, bond and balanced funds. GICs protect against the loss of capital and offer returns of about 5 per cent or more right now if you shop around. But historically they have not done a great job of delivering inflation-beating returns, even if they do protect against the ups and downs we’ve seen in the stock and bond markets this year.
“People are acting the opposite of how they should in an inflationary environment because of fear,” Ms. Kennedy said. “They’re exiting the market or thinking that a guarantee is actually going to solve the problem.”
Having a pension of any sort is a big advantage in retirement, but the lack of inflation protection in many pensions is a weakness. Your CPP and OAS will help in this regard, but you need to do more.
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Rob Carrick