Impact of Inflation on Financial Planning
There has been a great deal of discussion recently regarding inflation and whether it will continue to climb or retract in the near future. While some economists believe our current increasing inflationary trend is temporary due to the pent up demand created during the pandemic and businesses now opening back up, other economists believe we are on a trajectory of higher inflation for the next several years. Only time will tell which predictions are correct, but we can take steps to prepare for the possibility of increasing inflation.
First, let’s talk about what inflation is. Inflation is the measurement of the purchasing power of our dollars. When inflation goes up it generally costs us more to purchase goods and services, leaving us with less money in our pockets. A good example today is the cost of housing which has increased by as much as 30% in some communities, while salaries have only increased by approximately 2.5%, thereby eroding the purchasing power of those who are looking to buy a home. The same can be said for fuel, groceries, and a myriad of other goods and services that have seen increasing costs over the past year. This has resulted in Canada’s inflation rate increasing sharply to 6.8% in April, which is the highest we’ve seen in the past decade.
As inflation relates to financial planning, the big question is, what can we do to protect ourselves and our purchasing power? Let’s explore a few options below.
As inflation rises, it is often followed by increasing interest rates which results in higher borrowing costs. To protect against this, pay down household debt, especially if the interest rate is a floating rate like a credit card debt, line of credit, or renews in the near future similar to a mortgage. The less debt we owe when interest rates rise, the better position we will be in to weather the storm. As in the example below if interest rates increased from 2% to 4% on a $500,000 mortgage, your payment would increase by more than $6,200/year, leaving you with less income to pay other expenses or save. If you were able to reduce your mortgage balance by $50,000, the payment increase would only be $3,072/year, saving you $3,168/year.
|Current mortgage rates
|Increased mortgage rates
|Increased mortgage rate with reduced principal
|Savings with reduced principal
|Total of 300 Mortgage Payments
Interesting Fact: When inflation rose in the 1980’s, mortgage rates increased to more than 20%.
As the cost of living goes up, it’s important to manage our cash flow. Analyze where we are spending money and prioritizing these expenditures to determine where we might be able to reduce or eliminate some of these costs. This could be in areas of discretionary spending, like dining out, entertainment, or deferring the purchase of a new vehicle or boat. Making these changes will help to alleviate the strain of increasing costs in areas of non-discretionary expenses like taxes, heat, hydro, groceries, and debts.
Financial and Estate Planning
Increasing inflation has generally been good for the stock market, but it’s impossible to time it right unless you have a good working crystal ball, which most of us don’t. What we do know is that a well-diversified portfolio is essential to managing risk and providing us with the returns we need to meet our future goals. If we are in the accumulation phase of our life, it’s important that we continue building our savings for future needs, rather than suspend savings to maintain current lifestyle. Once we stop saving, it becomes much harder to start again in the future. For those who are in retirement and relying on their investment portfolio to provide them with income throughout their retirement years, it’s important that your portfolio be appropriately balanced with the ability to draw on specific assets as your income is required. As inflation increases, it can affect different asset classes in different ways. For instance, increasing inflation could have a positive influence on the equities in your portfolio while at the same time negatively impacting your bonds and some preferred shares. If your portfolio is designed to make prorated withdrawals from all assets, it could significantly impact your ability to recover when inflation returns to a more normal range. Conversely, if your portfolio is designed in a way that allows your portfolio manager the ability to pick and choose which assets they draw from each month, they could preserve the negatively impacted assets, allowing them time to recover without impacting your cash flow or the future value of your portfolio. So although having a diversified portfolio is important, it is equally important that you have the ability to preserve those parts of your portfolio that may be temporarily disadvantaged by the increase of inflation and higher interest rates.
If your estate plan is structured to provide for others, perhaps a spouse, disabled child, or grandchild or to provide for a charity that is important to you, then increasing inflation can have a significant impact on your planning since the money you intend to leave behind could be devalued. Imagine that you intend to leave an inheritance of $500,000 to fund the purchase of a home for your disabled child. When you initially developed your plan, this was sufficient to purchase a home for them. Unfortunately, with housing prices have increased by 30%, the funding would now be insufficient. It’s important to review your estate planning and determine if changes need to be made. Perhaps your current net worth no longer supports everything you wanted to achieve in your estate planning, that’s where insurance can play an important role. Using insurance to fill the gap between what you have and what you need to fulfill your estate planning goals is one of the most efficient tools available to us.
Financial and Estate Planning
With inflation already on the rise, now is a good time to meet with a CERTIFIED FINANCIAL PLANNER™ and review your planning to ensure that you are still on target to achieve your goals and objectives. If you are concerned about the effects of inflation, ask your financial planner to stress test your planning by running a scenario with higher inflation. If the higher inflation assumption in your plan is too low compared to reality, it could result in a significant reduction of income or possibly the depletion of your savings that could have devastating results to your financial and personal well-being. Knowledge is power and having this knowledge puts you in the driver seat where you can make decisions now to protect your future from the ravages of inflation.
If we plan for higher inflation and pay our debts down, improve our cash flow, enhance our estate planning, and update our financial planning and higher inflation doesn’t actually materialize, we have still have improved our current situation and protected ourselves from inflation in the future. As the former Prime Minister of the United Kingdom, Benjamin Disraeli once said, “Prepare for the worst, but hope for the best.” That is sage advice when planning your future.