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.
Early retirement is a wonderful dream, but in some cases that ends up being a nightmare. So let’s looks at some common pitfalls of planning for early retirement.
1) Underestimating expenses. It’s amazing how during your working left you get use to your lifestyle that you tend to forget about certain items like health benefits, replacing your car, your water heater, roof and the list goes on. When your planning for an additional 20 years of retirement you better make sure you check your expense list twice. One way to plan for this is to make sure when you go into retirement that everything is new or that you have planned for an extra replacement money. So for cars and houses a good minimum is $2000/year extra expense to cover those unusual expenses.
2) Not having any margin of safety on your calculations. It’s nice to hope that things turn out just the way you plan, but let’s face it, life doesn’t work that way. So you better leave some wiggle room when doing the math. In my case I drop my expected rate of return by an extra 1%. Some people like to boost their expenses by an additional 10%. Either way works out fine, but you do want to have some cushion there.
3) Not enough diversification in your investments. In order to avoid having your retirement savings go up in smoke you need to make sure you can suffer some serious damage to your savings. The solution is to avoid putting all your nest eggs in one basket. You most likely want a conservative mix once you get near retirement, but not too conservative that inflation takes you down in twenty years. So you most likely want a high interest savings account, bonds/CD’s, at least one REIT and a mix of other equities in Canada, US and the world.
4) Forgetting about taxes. Knowing your Canada or US tax law is required to build a good portfolio as much as diversification. For Canadians you need to know about the three types of investment income and how each is taxed.
5) Unrealistic expectations. You can’t travel the world and live in five star resorts and leave work at 30. Ok, perhaps one in 13 million can, but I know that isn’t me and most likely not you.
6) Emotional considerations. Some people do all the math and planning but forget one thing. What are you going to do with all that time? So they end up bored and go back to work. My question is what’s the point of saving if you don’t have a plan for your activities in retirement! Early on in your planning you want to start considering this. After all you don’t want to forget about enjoying your life now and you also want to ensure you will continue to enjoy your life in early retirement.
On my personal library shelf I have built up a small collection of some of my favorite retirement planning books. Out of all of these the one I like the best so far has been Stop Working – Start Living by Dianne Nahirny.
Dianne retired at age 36 and during her working life never made much of a salary (around $20,000/year), but she did make good money off a few house deals. She left the working world with a net worth of just $225,000. So the obvious question is with such a low net worth how is she financially independent? That is the lesson of the book: control your costs or they will control you.
Her book has two parts, the first part focuses on attitudes around money and how she came to her freedom day. More than anything what I was left with was the idea was to control your day to day spending and stop wasting money on things that don’t mean anything to you (ie: your power bill). That way you feel fine spending money on those luxury items you really want. In Dianne’s case, it was things like a antique gold locket, fur coat and a trip to Europe on the Concorde.
The second half of the book gets down to how to control your money. Some her examples are a bit extreme for my taste, but it proves the point. If your creative there is little no end in sight on ways to avoid costs and save money. The added bonus to her methods is you will be a kinder to the earth as you waste fewer resources. Which is exactly how I view it. I’m not saving the planet with low wattage light bulbs, I’m saving a few bucks and now have a $40/month power bill, so I’m taking that savings and building up to buy a new LCD TV.