The higher the inflation, the poorer we become.
Since everything costs more (transport, gas, food, housing, leisure, etc.), we have less money in our pockets.
But in addition, we are hit hard by the negative impact of inflation on our investments.
Example. For each $100,000 principal tranche of savings, if annual inflation stays at 5%, that means the “true” value of that inheritance at the end of the year will be worth only $95,238.
So, because of inflation, the “purchasing power” of that $100,000 will drop by $4,762, according to the Bank of Canada’s “Investment Spreadsheet,” which makes it possible to illustrate the financial impact of inflation on investments and savings.
WHAT TO DO ?
In order to be able to successfully compensate for this loss of purchasing power, savers are of course dependent on the investment returns that their capital can generate.
However, with inflation of at least 5% in 2022, the bar is set high. Very high.
To offset 5% inflation, she needs a minimum pre-tax return of 7.7% on her investments.
In the event that said $100,000 capital is invested outside of an RRSP, I have calculated that we would need to achieve a minimum return of 7.7% in interest income to successfully maintain our $100,000 purchasing power.
Why such a “big” return? Since interest income from all non-RRSP investments is fully taxable, there will be a tax charge.
However, for taxable income between $50,197 and $92,580, the combined federal and provincial marginal tax rate in Quebec is 37.12%.
So, assuming interest income of $7,700 per $100,000 principal tranche (7.7% of $100,000), you owe $2,858 in taxes. Which will leave a net income of $4842 in our pockets.
If we add this “interest income” of $4,842 to the value of our investment after inflation ($95,238), we find ourselves at the end of the year with real equity of $100,080, which is the same real wealth or, if you prefer, the same purchasing power.
In other words, we’ll end the year without actually having a dime in our pocket when we’ve achieved a 7.7% gross return on our investment.
Let’s get back to earth. An interest rate of 7.7% cannot currently be achieved. The best GICs (Guaranteed Investment Certificates) are currently yielding around 3.85% for a one-year term, or half the required yield (7.7%) to protect our purchasing power.
For bonds with a maturity of approximately 1 year, we get 2.8% federal bonds, 3.0% Quebec government bonds (including bonds distributed by Épargne Placements Québec), 3.25% municipal bonds and 3. 7% with corporate bonds.
For the purposes of our example, an investment of $100,000 at 3.85% yields $3,850 in interest income. After tax, we are talking about a net amount of $2,421.
If we add this interest income of $2,421 to the real value of the investment after inflation ($95,238), we will have real wealth of $97,659 at the end of the year.
So after 12 months our true wealth will be in a hole of $2341 compared to the original value of our $100,000 investment
The year 2022 promises to be all the more disastrous for our personal finances as the value of our investment portfolios has suffered year-to-date from the impact of the stock market slump and the significant bond market slump, with negotiable government and corporate bonds being traded.
So far, the Canadian stock market is down almost 10% and the US stock market is down around 20%.
Things aren’t much better for Canadian government and corporate bonds, with market values down around 13% year-to-date.
Being hit by both high inflation and a sharp decline in the financial markets severely weakens the portfolios of all involved.
And this phase of sharply rising interest rates could be devastating for over-indebted households.