Retirees are particularly vulnerable to the ravages of inflation, especially if they have to rely on their savings for income rather than on defined-benefit pensions.
This problem had lain dormant for several decades but now appears to have returned with a vengeance. The Consumer Price Index rose 5.7 per cent in February, 2022, over the previous year, and this may be just the start.
Assuming that higher inflation will be with us for a while, how should Canadians with savings but no DB pension adjust their retirement planning?
Of the many facets to this question, let’s focus on when to start receiving your Canada Pension Plan benefits. You can start CPP (QPP in Quebec) payments as early as age 60 or as late as 70. Waiting until 70 forces you to dip into your savings sooner than you might like, but the payoff is that the benefits will be at least 42 per cent higher than if you started it at 65.
I have long maintained that most people are better off waiting until 70 to start CPP, provided they have a normal life expectancy and enough savings to see them through their 60s. I base this conclusion on a calculation of present values.
This is an actuarial exercise that takes every scenario into account, such as what happens if you die at 66, at 67 and so on, up until age 110, weighting each scenario for the probability it will happen, then discounting the result for interest back to the present time.
In a low-inflation environment, I use an interest rate of 3 per cent for the calculation. In this case, waiting until 70 produces a present value about 20 per cent higher than starting CPP at 65. The choice of interest rate turns out to be important, especially if inflation is here to stay.
Let’s imagine that future inflation averages 5 per cent a year with future risk-free interest rates at 6 per cent. That seems outlandish now but would have been quite plausible in the late 1980s.
Consider a 65-year-old male whom we will call Dave. If Dave is entitled to a full CPP pension, the present value of that pension using a 6-per-cent interest rate is approximately $320,000 if he starts payments at age 65. If Dave waits until age 70, the present value rises to about $360,000 – an increase of about 12 per cent.
This is less impressive than the 20 per cent mentioned above, but it is not something to be ignored. In fact, further calculations show that both inflation and risk-free interest rates would have to nudge into the double digits, then stay there before the gain from deferring CPP payments disappears.
Not so fast, Dave might say. The above analysis looks at CPP in isolation. If Dave waits until 70 to start his CPP, he will burn through his life savings more quickly. Maybe that was acceptable when the risk-free interest he was earning was just 3 per cent a year, but what if he could achieve a higher return on his money in a high-inflation environment?
Let’s assume Dave has $600,000 in RRSP assets at age 60. We will continue to assume inflation at 5 per cent and a risk-free interest rate of 6 per cent. In this case, the total annual income at age 65 from CPP, Old Age Security and savings that Dave could expect is about $50,000 if he starts CPP at age 65 and about $53,000 if he starts it at 70. (To run this calculation, I used a version of PERC, a free retirement income calculator that is available online.) Deferring CPP still makes sense.
In conclusion, it is advantageous to defer starting CPP benefits, though the advantage shrinks with higher inflation and rising interest rates. On the other hand, higher inflation also produces higher anxiety. Retirees like Dave should have more peace of mind if they defer CPP to 70. That’s because more of their total retirement income will be fully indexed to inflation, no matter what happens.
Frederick Vettese is the former actuary of Lifeworks and the author of Retirement Income for Life.
