Time To Fill Inflation Buckets

Canadian financial experts tend to be an optimistic bunch. Many planners use a two per cent CPI indexation for their forecast assumptions. Even Canada’s chief actuary of Canada uses a two per cent inflation rate in its 75-year projections of CPP. They generally ignore the fact that inflation was higher than two per cent in 60 per cent of time and higher than four per cent in about 28 per cent of time since 1900. A difference of one per cent in the inflation assumption can be the difference between a successful outcome and a dismal one.

It is true that inflation has been relatively low for the last several years. There are two factors that this is changing: the pandemic brought the supply-side issues and labour shortages and ongoing military conflicts and political discords are straining the currency and food supply balances further. The globalization process of the last 40 years was one of the contributors to low inflation. Now, the race to globalization is questioned more often. The net outcome of these is that inflation has been hitting 40-year highs. Being raised in a country where a 25 per cent annual inflation was ‘normal’ and a 60 per cent inflation was ‘somewhat high,’ I know first-hand that the line between ‘normal’ and ‘unimaginable’ can be thin, very thin.

Many life annuities and company pensions do not come with full CPI indexation. If this money is needed for essential expenses, then the retiree needs an ’inflation bucket.’ We use a multiplier to calculate how many dollars of additional savings you need for each dollar of annual income. The following tables indicate asset multipliers for different retirement ages and indexation methods.

Here, we cover three of the most popular indexation methods: fixed, partial, and differential. To make sure that the inflation bucket is as reliable as the underlying income stream, they are calculated for a zero per cent historical failure rate to last until age 96.

Income Streams With Fixed Indexation

A fixed indexation means the income is indexed annually by a fixed amount each year. Table 1 shows the asset multiplier to calculate the inflation bucket for income streams with zero per cent, one per cent, and two per cent annual indexation.

Table 1: Asset multiplier for an annuity or pension income with fixed indexation for life

RetirementAgeAsset MultiplierIncome stream is indexed by 0 per centIncome stream is indexed by 1 per cent Income stream is indexed by 2 per cent 6013.011.710.26511.510.39.0709.68.77.7757.87.16.3806.05.34.5

If you have fixed indexation, you might sometimes have a surplus. For example, if the annuity payment is indexed each year by two per cent and CPI was only 0.5 per cent last year, then you have a surplus of 1.5 per cent for this year. Figures in this table are based on all surplus deposited back into the inflation bucket and not spent.

Income Streams With Partial Indexation:

A partial indexation is when the annual indexation of a pension or annuity payment is a portion of the actual CPI. Table 2 shows the asset multiplier to calculate the inflation bucket for income streams that are indexed by 30 per cent of CPI, 50 per cent of CPI, and 70 per cent of CPI.

Table 2: Asset multiplier for an annuity or pension income, indexed partially for life

RetirementAgeAsset MultiplierIncome stream is indexed by 30 per cent of CPIIncome stream is indexed by 50 per cent of CPI Income stream is indexed by 70 per cent of CPI 6010.48.25.4659.17.14.7707.65.93.8756.14.73.0804.33.32.1

Income Streams With Differential Indexation

A differential indexation is when the annual indexation of a pension or annuity payment is less than the actual CPI by a fixed amount. For example, ‘CPI less two per cent’ means when CPI is 3.5 per cent for a particular year, the pension payment is indexed by 1.5 per cent. It also means when CPI is two per cent or below, there is no indexation, the pension income stays the same. Table 3 shows the asset multiplier to calculate the inflation bucket for income streams that are indexed by CPI less one per cent, CPI less two per cent, and CPI less three per cent.

Table 3: Asset multiplier for an annuity or pension income, indexed differentially for life

RetirementAgeAsset MultiplierIncome stream is indexed by CPI less 1 per centIncome stream is indexed by CPI less 2 per cent Income stream is indexed by CPI less 3 per cent 603.35.98.0652.75.06.9702.13.95.5751.62.94.1800.981.92.7

Here is an example showing how to calculate how much you need in an inflation bucket:

Jeremy and Claudine are both 70, just retiring. Claudine has a company pension that pays $22,000 per year, indexed annually to half of CPI. Jeremy has a life annuity that pays $13,000 per year with no indexation.

What size of inflation buckets do they need?

Inflation bucket for Claudine: For partial indexation, look up Table 2, age 70 and 50 per cent of CPI. The asset multiplier is 5.9. She needs an inflation bucket of $129,800, calculated as 5.9 × $22,000.

Inflation bucket for Jeremy: For fixed inflation, look up Table 1, age 70 and 0 per cent indexation. The asset multiplier is 9.6. He needs an inflation bucket of $124,800, calculated as 9.6 × $13,000.

The total inflation bucket that Jeremy and Claudine need is $254,600.

With these two inflation buckets in place, they now have $35,000 per year income (calculated as $22,000 + $13,000), indexed to CPI for life.

History shows that we need to pay close attention to inflation. Simply assuming a two per cent inflation for the foreseeable future is no longer an option. You will likely need to revisit existing plans to make sure they are still realistic. Inflation buckets that are sufficiently filled, can help clients navigate through their retirement safer.

Jim C. Otar (B.A.Sc., M. Eng.) is a retired engineer, and financial planner, and the founder of www.retirementoptimizer.com. This article includes excerpts from his book and CE course, ‘Advanced Retirement Income Planning.’