Inflation and Pensions

At about Christmas, when there was a shortfall in pension funds, the Ontario Teachers Pension Plan announced that retired teacher's pensions would no longer be indexed to inflation. Depending on the assets held by the Pension Plan, from years after 2009, it may only be indexed to half of inflation.

Lets run some numbers to see how damaging this could be. To make the numbers convenient, I will use a salary of $100,000 at retirement (it sounds like a lot, but 30 years from now when I retire that probably is what it will be at). As well, we will use various inflation rates, all indexed to half of that. What the index means is that your money that you get will be increased by half of inflation. So if inflation is 2%, you will get 1% extra money. The problem is that the cost of everything has gone up 2%, so that although you are making more money, you have less money to spend.

Scenario 1: $100,000 at retirement and 2% inflation
- after 5 years: salary is $105,101.01
- spending power (relative to $100,000): $95,193.22 (you can purchase five years from now the same as if you made $95,193.22 in the first year)
- after 10 years: salary is $110,462.21, spending power: $90,617.49
- after 20 years: salary is $122,019.00, spending power: $82,115.29
- after 30 years: salary is $134,784.89, spending power: $74,410.81

So after 30 years, your salary will only purchase about 74% of what it did when you started retirement. If the average teacher retires at 55 or so, this is at 85 years of age, where people will still be around (as we continue to live longer).

Scenario 2: $100,000 at retirement and 4% inflation
- after 5 years: salary is $110,408.08, spending power: $90,747.39
- after 10 years: salary is $121,899.44, spending power: $82,350.90
- after 20 years: salary is $148,594.74, spending power: $67,816.70
- after 30 years: salary is $181,136.16, spending power: $55,847.66

So after 30 years in the second scenario, you will only be able to purchase about 56% of what you could when retirement started. This is where things start to get scary. Since the early 90s, governments have tried to keep inflation at 2% (or less), but any period of hyperinflation (in the 8-10% range) and this could cripple lots of people's retirements.

Scenario 3: $100,000 at retirement and 6, 8, 10% inflation
- after 30 years at 6% inflation: salary is $242,726.25, spending power: $42,261.10
- after 30 years at 8% inflation: salary is $324,339.75, spending power: $32,232.02
- after 30 years at 10% inflation: salary is $432,194.24, spending power: $24,768.43

OK, this is starting to get a bit ridiculous. No one expects 10% inflation over the next 30 years. It is possible though to expect inflation in the 2-4% range, where at least one third of your money will have eroded.

Even if you aren't a teacher, please take a look at your pension to see if this holds true. Inflation is very dangerous to your spending power in retirement, where it can be difficult to make more money (unless you have saved for your retirement outside of your pension).