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 Summer 2000

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:

  1. A "flat benefit" plan is one that provides a fixed dollar amount multiplied by the participant’s months or years of service. After qualifying for a pension, the employee’s benefit is calculated as a flat amount that he will receive monthly for life;

  2. a "career average" plan considers the employee’s average earnings throughout his years of employment, takes a percentage thereof and multiplies this figure by his years of service. Onceagain,the participant’s pension will remain at a fixed dollar amount for as long as he receives benefits under the plan; or

  3. a "final average plan" that calculates the participant’s 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 today’s 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 1990’s 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 again.

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 today’s 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 today’s 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.

SUMMER 2000: Introduction to Retirement Income | Pension Plans: The Nuts and Bolts | Show Me the Money | The Effects of Inflation on Pension Benefits |Sample Pension Statement

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