Effects of Inflation on Financial, Estate and Retirement Planning and product illustrationsIan Whiting
After reviewing different options for growth rate assumptions in previous blogs, let’s now examine inflation. From Statistics Canada’s website, the following inflation rates apply for the same 1992 to 2011 period.
1992 1.8 %
1993 1.4 %
1994 0.2 %
1995 1.5 %
1996 1.9 %
1997 0.7 %
1998 0.9 %
1999 2.4 %
2000 3.0 %
2001 0.7 %
2002 3.7 %
2003 2.1 %
2004 2.2 %
2005 2.2 %
2006 1.8 %
2007 2.6 %
2008 1.3 %
2009 1.5 %
2010 2.7 %
2011 2.7 %
Average 1.87 %
Median 1.85 %
CAGR 1.86 %
Inflation has ranged considerably since the 1950s – from mid-double digits (during the period of a strange PET creation called the Anti-inflation Board) to a minus during a recession. Even in this illustrative period it has gone from 0.2% for a low to a high of 3.7% – more than 18 times the lowest rate!! 3.7% is a plan killer – particularly over 20 or 30 years – and remember from a couple of blogs back, this is just the main CPI result – sub-indices for things such as Health Care and Recreation can be and very often are considerably higher – which results in an even larger impact post-retirement than just the basic CPI. But let’s continue the basic thread here.
If I take the Average, Median and CAGR results from one of the previous blogs and subtract these inflation figures, look at what happens.
Net Average 4.98 % $2,640.69 Overstated by 32.20 %
Net Median 8.00 % $4,660.96 Overstated by 133.34 %
Net CAGR 3.52 % $1,997.49
You can see that the Net Average drops from 6.84% to 4.98%; the Net median is reduced from 9.85% to 8.0% and CAGR drops to 3.52% from 5.38%. Putting these inflation-adjusted rates into the usual future-value formula, using the Net Average rate results in the initial $1,000.00 invested growing to $2,640.69, the Net Median gives $4,660.96 while using the Net CAGR provides a total of $1,997.49 after the 20-year period. I will further complicate this discussion by taking the CAGR from the blog adding money to the fund – 5.01% and subtract the 1.86% CAGR for inflation, and now I get a Net CAGR of only 3.15%!!
I am going to ignore the Median calculations in my future comments – and you can obviously see why – that leaves either the Net Average or the Net CAGR.
The CAGR is the actual calculated Compound Annual Growth Rate for the initial $1,000.00 investment over 20 years – it takes into account the actual up and down movements for each year to give the actual end result. The numerical Average does not consider the actual end result of the annual changes to the rates of return – rather just the annual rates themselves. Which, IMHO, is seriously flawed logic. As you can see from the table above, using the Net Average results in projected future values 32.20% HIGHER than actual history would indicate – can you justify an error rate this large to yourself or your clients??
I was told by a statistician many years ago that averages are nothing but the worst of the best and the best of the worst – reviewing these numbers proves that statement to me – and I hope to my readers as well.
Talking to various actuaries (a very interesting group of folks I might add) over many years, particularly pension actuaries, I have been told many times that the real rate of return on money over long periods of time (30 plus years), is typically in the 3.00% to 3.50% range – RROR being return over and above inflation but before taxes – and surprise, surprise, this is what is supported by the actual results over the previous 20 years using the S&P/TSX Total Return Index and applying the Stats Canada CPI and actual calculated Compound Annual Growth Rate!
Next time, I will discuss another favourite hobby-horse – income taxes! Cheers
Posted: July 20th, 2012 under Asset Allocation, Cost of Living, Debt, Estate Planning, Finance, Financial Planning, General, Government, Guaranteed Investment Certificates, Insurance, Investments, MONEY®, Mutual Funds, Pension, Personal Finance, Saving, Tax-Free Savings Account, Taxes.