Wednesday, 20 May 2009

Inflation Ain't What It Used To Be If You Are Retired

Did you know that inflation is usually higher for retired people? At least it is to the extent that Canada is the same as the USA. Moshe Milevsky in a January 2009 presentation along with the heavy duty paper version on Lifetime Ruin Minimization at the IFID website reveals that the mainstream average inflation calculation understated that experienced by older people (age 62+) by about 0.5% a year since 1983. The reason is that retirees spend a much greater proportion of their income on housing and health care as this breakdown chart from the presentation shows.

Are things the same or different in Canada? Unfortunately, there is no such alternate inflation measure put together by Stats Canada. I phoned them just to be sure and they said they don't have one. It would be very helpful e.g. for the government to use to adjust CPP, OAS, GIS and other payments to retirees. Of course, different parts of the country have different inflation rates, not to mention large differences because of lifestyles. Another neat idea on the BBC website is a personal inflation calculator - just plug in your own spending habits and it takes the UK individual CPI components (called Retail Price Index in the UK) and adds them up with your spending proportions.

A negative consequence is that one financial product's effectiveness is undermined for retirees. Real Return Bonds are meant to counteract the effects of inflation by indexing the principal and interest using CPI. If an understated CPI is used, RRBs won't go up fast enough. The Milevsky presentation has another chart on page 10 that shows very poor correlation between the CPI-E (E = Elderly) and actual returns from US RRB funds, in other words the returns from the RRBs didn't match up with inflation from year to year at all. In fact, as a result of such poor performance, Milevsky concludes that RRBs should treated as just another asset class within a portfolio by retirees.

Canadian Capitalist had an interesting post Investing in a Period of High Inflation with good comments about RRBs. One commentor's statement that the Canadian RRBs use only Core Inflation, which strips out the more volatile, but essential to most people, components of mortgage interest, energy and food instead of the overall Total CPI is incorrect. The RRB fact sheet on the Bank of Canada website says the CPI measure used is the "All-items" CPI, which a Bank of Canada spokesperson confirmed is Stats Can's Total CPI.

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