October 10, 2020Financial literacy
Money Illusion and GIC Investing
For most investors, risk is a difficult concept to appreciate fully. Not only are the traditional definitions cumbersome to quantify, but types of perils can vary wildly. Permanent loss of capital and volatility are apparent, but other risks can also affect the enjoyment of your retirement critically.
When it comes to assessing risk, the most conservative investors tend to focus on investment safety and guarantees, but those come at a cost. The hazards of current guaranteed interest rates are not easily recognized. Yet, the danger is just as malicious to a financial plan. Ironically, it's the risk-averse investors that are critically affected by money illusion.
Money illusion is the predisposition to think of wealth in terms of what it can buy today. You can see this effect in action when your aunt gives you $50 each birthday for the last 25 years. It used to be a generous gift, but it doesn't amount to much anymore after years pass.
In today's highly volatile capital markets, investors who can't stomach the fluctuations have hunkered down in good old Guaranteed Investment Certificates (GICs) and other 'low-risk' investments. Although it only pays a modest rate of return, they assume that the value is intact. The principal may be the same number but what you can buy with it in the future diminishes when interest rates are lower than the pace of inflation.
Imagine that you live a conservative lifestyle with $50,000 per year in spending that you plan to fund from your investments. Suppose that your local bank is offering GIC rates of 3% interest. After allowing for modest taxes, it would take about $980,000 in savings to fund your expenses over the next 30 years.
The risk that you are taking, however, is the loss of your purchasing power over time. Money illusion tends to neglect the impact of rising costs – and therefore diminishing the value of money – over time.
The Bank of Canada has an objective to grow Canada's economy by 2% per year. That means that the costs of goods and services are expected to increase each year by about that much. More importantly, the rising costs compound. Next year's increase is based on this year, and so on. That means that your $50,000 of expenses today will cost you $74,300, 2 decades down the road.
People are not naturally programmed to think in terms of compounded price increases, and we have a challenging time digesting the impact of inflation.
In the face of rising costs, a GIC investor loses purchasing power since interest rates are less than the pace of rising prices. What a portfolio of so-called low-risk investments will afford you at the end of your retirement will be substantially less than it is today. If you want to invest in low-interest guaranteed notes, be forewarned. Even at a 3% return and a 2% inflation rate, you will need to save over $1,500,000 to keep up with $50,000 in today's costs. That's a 53% larger nest egg than without inflation.
Copyright Solinvest 2020