Before all of you whole-foods types get up on your soapboxes and start ranting about how terrible my sugar water addiction is for me (Yes, my name is Kyle and I am an addict – I drink 1 can of pop a day), let me stop you. While Coca-COLA is pretty sweet as well, the COLA I’m referring to short for Cost Of Living Adjustment. When most people take a look at their retirement plans and try to figure out what their annual income will look like going forward they often struggle when it comes to determining just how much money they can expect from their pensions, and just what role inflation should play in their calculations.
My Pension is Going to Shrink?
It doesn’t take long to figure out that with increased life expectancies these days if you retire at 55 on a pension of $35,000 a year, that 35K might not buy you the same thing at 85 as it did at 55. In fact, if the Bank of Canada achieves its goal and keeps general inflation to around 2% per year over the long term, your 35K pension is going to be able to buy about half of what did when you first retired.
Obviously this isn’t an ideal situation. Most people look at statistics like that and decide that working another 5-10 years “just to be sure” is probably best for them. This line of thought is generally encouraged by many financial advisors who have a strong incentive to convince you to keep earning and investing dollars as opposed to retiring and beginning to take money out of your investment holdings (see: commissions, mutual funds). If you are fortunate to have a pension plan with a COLA however, then this will help soften the blow from inflation’s left hook.
The Magic Formula
COLAs are usually negotiated into pension plans by unions and are often based on some formula that will protect the purchasing power of your pension plan to some degree. Most of the time these formulas are based around the Consumer Price Index (CPI). This index seeks to quantify the general inflation across Canada for a given year. It takes a look at a few hundred products and services that most people spend money on and calculates the average amount that prices went up (or down in rare cases) that year.
Most pension plans can’t afford to increase your payout at the full rate of inflation as determined by the CPI every year (in fact most pension plans can’t afford any COLA at all, but that’s another long story). Instead, the compromise most plans make is to increase the payouts by a certain percentage of the CPI year after year. For example many teachers’ pension plans that I familiar with have a COLA of 2/3rds the CPI. Therefore, if you had a pension of $30,000, and inflation was 3% that year, your pension the following year would go up 2% to $30,600. Your money will still buy a little bit less than before, but it is more protection than most retirees will get from inflation. Other common COLA formulas I’ve seen are 60% of CPI, 75% of CPI, and the CPI rate -1%.
Want to Stir Up a Room of Non-Government Workers in a Hurry?
COLAs are often pointed to a as a cause of the pension envy from private sector retirees. I couldn’t find any statistics about the Canadian private sector, but in the USA, it is now estimated less than 10% of pension plans in the private sector (and remember, many places don’t have and plans at all) have COLAs. The numbers might be a shade higher for Canada if one takes into consideration the respective attitudes toward labour laws in each country, but there is little doubt that the public sector has a major advantage when it comes to this part of their compensation package.
When you think about how much capital it takes to produce the equivalent of a $35,000 pension, the numbers often stagger people. Most actuaries would say you’d need about $1 million in the bank to approach that level of annual income. When you factor in a COLA that prevents that number from losing any great amount of value over time, that pension becomes substantially more valuable. Because of this basic math, and Canadians general refusal to save for their own retirement, many people are advocating for a large increase (double? triple?) of the CPP program as a means to insurance all Canadians have access to some sort of retirement income that is partially inflation-adjusted. Personally, I like to keep control over my own pension funds, but I do see the rationale behind it. I wonder if there might be a way to opt-out of a semi-automatic top up of CPP investments?
I’m sure one day people will look at the cola I drink every day like we look at cigarettes now. The minority of people who enjoy a COLA however will likely be envied to a large degree by the rest of society.