The Effects of
Inflation on Pension Benefits
AN EARLIER ARTICLE EXPLAINED the existence
of defined benefit pension plans. Under these plans, the member, upon retirement will
receive a monthly benefit that has been "defined" under the bylaws of his
particular pension plan.
Benefits under such plans are usually
determined under one of the following three variations:
A "flat benefit" plan is one
that provides a fixed dollar amount multiplied by the participants months or years
of service. After qualifying for a pension, the employees benefit is calculated as a
flat amount that he will receive monthly for life;
a "career average" plan
considers the employees average earnings throughout his years of employment, takes a
percentage thereof and multiplies this figure by his years of service. Onceagain,the
participants pension will remain at a fixed dollar amount for as long as he receives
benefits under the plan; or
a "final average plan" that
calculates the participants pension as a function of earnings in his last few years
before retirement, or alternatively, his years of highest earnings. But, once again, his
monthly pension, when calculated, provides him a fixed dollar pension that he can expect
to receive each month.
All of the above is fine as at the date of
retirement. However, inflation hurts those on fixed incomes and as long as the recipient
of the pension does not see his pension increase with the cost of living, he will witness
the erosion in purchasing power of his monthly stipend.
Unless todays retiree had the good
fortune of contributing to a public (government sponsored) pension plan, it is a good bet
that he is receiving his pension with the same number of nominal dollars each and every
month. Unfortunately, cost of living, even though it has moderated somewhat these
past few years, increased every year of the 1990s and is likely to continue on the
same course in the foreseeable future, Every increase in gasoline at the pump or a
one-cent drop in the Canadian dollar increases the fears that higher inflation may be back
Above, you will find two sets of tables.
The table on the left indicates how inflation erodes the purchasing power of the dollar.
For example, if you are 49 years of age today and you dream of collecting your pension at
age 65, you have sixteen years to contribute to your plan.
By looking at 16 in the column marked
"year" on the table on the left, you will notice that even with an extremely low
inflation rate of only 2% per annum, the purchasing power of todays dollar will be
only 73 cents when it comes time to retire. If you feel that 2% is unrealistically low,
the table shows that with an inflation rate of 4% per annum, the purchasing power will
only be 58 cents on the dollar.
More important than that, however, is a
look at the purchasing power of what a fixed pension amount will be able to buy sixteen
years hence. The table on the right indicates that goods or services that cost $1 in 2000
will sell for $1.37 in 2016 under an assumed inflation rate of 2% per annum or $1.87 if
inflation were pegged at 4% per annum.
It is unrealistic to believe that sponsors
of todays pension plans will provide indexed pensions anytime soon without
government legislation mandating such changes. The value of the accompanying tables is not
to scare the reader as to what he might expect in the future, but rather to alert
contributors to pension plans that perhaps they should seriously consider having an RRSP
as well as a RPP in their retirement portfolio.
It would appear that even the most generous private pension
every month, plan will be insufficient in and of itself to provide adequate retirement
income and steps should be taken now to prepare for this reality.