Inflation Risk and Your Pension Plan

In my humble opinion, inflation risk represents the single largest threat to your investment portfolio. We're all aware of inflation and we all understand inflation, yet very few people plan properly for the devastating effect inflation can have on the real value of their investment portfolio. In the world of investment and retirement planning, inflation is truly the silent killer. If you doubt what I'm saying, you only have to look as far as the nearest actuarial table. An actuarial table is the set of data that life insurance companies use to predict how long an individual of a certain age can be expected to live. We all know that the average life expectancy for a man in the US is about seventy-five, and for the average American woman it's about six years longer. What a lot of people forget to consider is that by virtue of the fact that you're reading this, you're not average. The average includes all the people who perished from tragic accidents in their youth, all the souls taken from us in car accidents and all those lost before their time to diseases. The unfortunate people who die young have the effect of significantly pulling down the average life expectancy. It is after all, the average life expectancy.

If you're fifty years old, it's a fair bet that none of these things happened to you, or if one of them did, you recovered. Because of all of the things that didn't happen to you, the average life expectancy no longer applies. Or rather, it's no longer specific enough. To get an accurate idea of how long you'll be around, and thus how long your personal pension plan needs to support you, we need to consider how long the average person-who is your age-will live. Actuarial tables show us that the average fifty-year-old male can expect to live well into his eighties and the average female can still expect to live about six years longer. If you're married, then the odds are that at least one of you will be spending that pension money at bingo well into your nineties.

By the way, new medical discoveries and improvements in medicine are not even considered in this type of actuarial table. If you're younger than fifty, or if you're hopeful of new breakthroughs in medicine, then it's only prudent to assume that either you or your spouse will still be around to see your one hundredth birthday.

Depending on when you retire, it's likely that your investment portfolio will have to support you for at least thirty years. If you're married, or younger than fifty, then forty years isn't out of the question. Over that length of time, inflation can have a devastating effect. Just a couple of years of high inflation at any point in your retirement could permanently reduce your standard of living by twenty to thirty percent. The long-term inflation rate in North America is a little more than three percent. That's not too bad. But even inflation of three percent will increase your expenses by almost 250 percent over a thirty-year retirement. If you're having trouble with this concept, just take a quick trip down memory lane. What did a stamp cost you thirty years ago? What did a movie cost? If you're too young to remember, make a mental note to ask your parents next time you speak with them. It makes for a fun and enlightening conversation.

Fortunately, inflation risk, like all of the five big risks, can be managed. There are several effective tools used by the great pen­sion plans, but they basically boil down to real estate, equities and real return investments. The term "equities" is just a polite way of saying stocks. It refers to the fact that a share in a company entitles the owner to an equity ownership in the company. The vast majority of companies are effectively immune to inflation. As prices and costs rise, companies simply pass those price increases along to their customers. Inflation actually helps many companies, because price increases often give them an opportunity to build more profit into the final purchase price. There aren't a lot of guarantees when it comes to investing in equities, but the great pension plans know that good companies are inflation-proof. You can take that to the bank.