Inflation may be more of a risk than you think

Inflation hasn’t been a top-of-mind concern for several years. But if you’re living on fixed-income investments, perhaps it should be. It’s like water steadily dripping on a stone. Sooner or later, it makes a hole.

Let’s say you’ve got $10,000 put aside and you want to put the money somewhere safe. A small trust company is offering six percent interest on a five-year GIC, paid annually. That’s a better rate than the banks are paying and it represents $600 income each year, rock-firm. And, of course, the investment is protected by deposit insurance. The Canada Deposit Insurance Corporation, an agency of the federal government, will ride to your rescue if anything should happen to the trust company. It looks safe and solid. If anything is risk-free, this is it, right?

Well, not really.

Inflation was not a problem through much of the 1990s but as we moved into the new century it began to pose some concerns again. Governments and central banks will do everything in their power to prevent runaway inflation from taking hold again, perhaps even to the point of plunging the economy into recession. But inflation in the two to three percent range over thnext few years is a real possibility.

Let’s suppose the inflation rate when you invest your money is two percent. Over the five-year period, it increases modestly, at a rate of half a percent per year. How much money, in real dollars adjusted for inflation, will you actually earn over the five years?

Take a look at the table below.

End of Year

Gross Income

Inflation

Rate

Real Return

(Inflation Adjusted)

1

$600

2.0%

$588.00

2

600

2.5%

573.30

3

600

3.0%

556.10

4

600

3.5%

536.64

5

600

4.0%

515.17

 

As you can see, even at modest rates of inflation, your before-tax real return falls from six percent at the time of purchase to just over five percent at maturity. Plus, the $10,000 you’ll get back from the trust company at maturity will have a purchasing power of just under $8,600. Your safely invested capital has dropped in real value by more than 14 percent. And this during a time when inflation is low!

If someone had told you in advance that the investment you were about to make would drop 14 percent in value over five years and that the value of the income it generated would be steadily eroded, would you go ahead anyway? Probably not!

Inflation is a risk with any fixed-income investment. The longer the term, the greater the risk. At an annual inflation rate of three percent, a $50,000 investment will be worth only about $36,900 in terms of real purchasing power after 10 years.

You protect yourself against inflation risk by having part of your portfolio in investments that will appreciate in value: stocks, equity mutual funds, and real estate are the three used most often. These are often regarded as higher-risk investments, but not to include them will expose you to an unacceptable level risk of another kind. It’s a matter of balance.

Adapted from Gordon Pape’s new book 6 Steps to $1 Million, published by Prentice Hall Canada. To order a copy at 15% off the suggested retail price, go to: http://www.gordonpape.com/bookstore/productdetail.cfm?product_id=277