For the last week or so I’ve been a bit of dog with a bone about inflation. It comes up in every retirement calculator and I started wondering how much of a concern this really is in retirement spending. Is inflation a real concern or just a spectre of fear that the investment industry uses to get you to save more?
Since this topic ended up growing a bit more than I had first planed on I’ve had to break it up into a couple of posts. Today we will start off with a little education session for those not familiar with inflation. Inflation is the measured with the Consumer Price Index (CPI) which consists of a basket of good which the government tracks on a monthly basis to track the tendency of prices to increase over a long period of time. In Canada, the data comes from Statistics Canada, but the Bank of Canada is the one using the data to determine if inflation is being controlled within their set target range which is currently 1 to 3% over an entire year.
Since the CPI consists of several volatile components (like fruit, veggies, gas and heating oil) the Bank of Canada likes to strip those out to get a better idea of the core inflation. The core CPI consists of 84% of those items in the total CPI. This core rate is used as a operational guide to ensure the bank is keeping inflation with in their target. For example the core rate of inflation was measured at 2.0% in December 2006, while the total CPI was 1.6% (see here for more data).
Now in general the CPI is useful since Canada Pension Plan (CPP) and Old Age Security (OAS) benefits are adjusted to reflect changes in the CPI rate. Yet despite it’s almost universal acceptance of the measure of inflation in Canada, it does have some problems when using it for personal calculations such as retirement estimates.
The CPI’s basket of good goods is based on the national average of a an urban Canadian’s spending habits. The spending habit data is only updated every four years, which means the CPI’s basket of goods lags the current average Canadian’s spending habits by up to five years (four year between gather data and 1 extra year to process it). Another problem of using the average Canadian is it tends to skew the spending to those in the upper middle class, since their larger incomes tend to shift the average spending up. Another problem with the CPI’s basket is it only uses urban data, which means it doesn’t reflect any rural spending habits. Also using a national number doesn’t reflect your regions inflation particular issues. For example, Alberta’s inflation is significantly higher than Nova Scotia’s due to current regional economic conditions.
All of these issue contribute to the bias of the CPI and on average it is estimated it is 0.5% higher than real inflation. Which means if your using a calculator with a 3.0% inflation rate, your overshooting the average by at least 0.5% a year. Tomorrow we will look at some more data to try and come up with a better inflation number.