The Best Inflation-Fighting Investments for Retirees
In-retirement portfolios should include a blend of inflation hedges and inflation beaters.
In a 2019 Society of Actuaries survey, pre-retirees and retirees were asked about the issues that worried them most about their money in retirement.
Topping the worry list for pre-retirees? That the value of their investments might not keep up with inflation. Nearly two thirds of pre-retirees cited inflation as a key worry--tied for the top slot with concerns about long-term-care expenses and ahead of worries about higher healthcare costs.
At first blush, inflationary worries seem misplaced: After all, inflation averaged less than 2.0% between 2011 and 2020. Thanks to the pandemic, it was just 1.4% in 2020.
Yet worries about inflation have been simmering in recent months, thanks to massive amounts of fiscal stimulus, a resurgent economy amid rapid uptake of the vaccine, and pent-up demand for spending once the pandemic is finally under control. The so-called break-even rate--the differential between what nominal 10-year Treasury bonds and Treasury Inflation-Protected Securities yield--recently shot up to 2.3%. That break-even rate, widely viewed as a proxy for market participants' inflation expectations, is nearly 2 percentage points higher than it was a year earlier, when pandemic worries pointed to a sustained economic slowdown.
Of course, market watchers also warned of higher inflation coming out of the last financial crisis, but widespread higher prices didn't materialize. The Federal Reserve has also indicated that it doesn't believe inflation is a huge issue at this juncture. Instead, it's likely that the baby boomers nearing and entering retirement today are recalling times in the not-so-distant past when higher prices were a bigger threat: The inflation rate jumped over 7% in the 1970s and more than 5% in the 1980s.
Pre-retirees and retirees can protect their plans against inflation in a few different ways. They can make sure they're factoring in their own situations and spending patterns when deciding how big a deal inflation is for them. Inflation should also play a role in how they think about taking withdrawals from their portfolios. Finally, retirees can confront inflation with their portfolio holdings, to ensure that the purchasing power of their investments isn't gobbled up by higher prices over time.
When thinking about how to inflation-protect a portfolio, I think it's useful to segment those inflation-fighting investments into three key groups: broad inflation hedges, narrower inflation hedges, and what I call "inflation beaters"--investments that don't track inflation directly but that have historically out-returned inflation by a healthy margin over time. We tend to need the hedges more when we're older than when we're younger, while investors of all ages need their investments to beat inflation--at a minimum.
Here's a closer look at how these categories have worked to mitigate inflation risk, as well as reasonable allocations to these groups.
How They Can Help: Inflation hedges are investments whose values go up when higher inflation comes on line. These investments can be further subdivided into two groups: those that aim to reflect inflation broadly, as measured by the Consumer Price Index, and those that reflect higher prices in a smaller basket, such as commodities or real estate.
In the former group, TIPS and I Bonds both help the value of their investors' accounts keep pace with the Consumer Price Index for All Urban Consumers (CPI-U). If inflation, as measured by the CPI-U, goes up, the TIPS owner receives an increase in his/her principal value. If inflation goes down, the principal value goes down, too. The interest paid on the bond is also indirectly affected by these changes to the principal value. Upon maturity, TIPS owners receive their original principal or the inflation-adjusted principal, whichever is greater.
I Bonds work similarly. In addition to a fixed rate of return set when the bonds are purchased, I-Bond holders also receive semiannual adjustments to their interest levels based on changes to the CPI-U. A crucial difference is that TIPS holders receive semiannual interest payments, whereas I-Bond holders receive their accrued interest when their bond matures or they redeem it. I Bonds offer tax deferral because of that feature; the income isn't taxed until the bond is redeemed.
From a practical standpoint, many investors opt for TIPS mutual funds for simplicity and ease of use. Moreover, I Bonds have severe purchase constraints that limit their effectiveness for larger investors who are aiming to build a significant bulwark against inflation. Investors are limited to $10,000 in electronic purchases of I-Bonds per Social Security number per year, and an additional $5,000 in paper I-Bond purchases are available for each Social Security number per year.
How Much: Because they offer inflation protection, principal protection, and government backing, TIPS seem like the ideal asset for retirement. But TIPS' return potential is low: TIPS' yields are currently negative, with the assumption being that TIPS' future inflation payments will make holding them worthwhile. And in contrast with nominal U.S. Treasury bonds, the TIPS market has sometimes seized up in equity market shocks; TIPS haven't been as reliable as ballast for equities as Treasuries or cash have been.
So, what's the right amount to hold in TIPS in retirement? Most professional in-retirement allocations geared toward people in retirement steer anywhere from 10% to 25% of their fixed-income allocations into TIPS. How to allocate within that range? Consider a couple of factors: how much inflation is impacting you personally (based on your customized inflation rate) as well as how much of your income you're drawing from your portfolio. If the answer is "a lot" on both counts, then it makes sense to be at the high end of that range. If you're not feeling a big inflationary pinch and/or nonportfolio income sources like Social Security provide most of your income needs (Social Security itself is inflation-adjusted), then the lower end of the range makes sense.
How They Can Help: Another category of inflation hedges reflect price changes in narrower slices of the economy, either directly or indirectly. Commodities-tracking investments are the best example in this category: They aim to reflect price changes in items like basic materials, energy products, and agricultural products, which in turn affect the prices we pay for a lot of our basic needs. My colleague Amy Arnott recently discussed how commodities-tracking indexes have done a decent job reflecting the trajectory of inflation.
Other inflation hedges in this group are narrower still. For example, real estate investment trusts have fared reasonably well as inflation hedges. That's because the owners of the apartment and office buildings, shopping malls, and hotels in REIT portfolios are often pushing through rent increases at times when inflation is running up, which in turn enhances REIT payouts and security prices.
Contrary to conventional wisdom, gold hasn't been a particularly effective inflation hedge, even though it's often cited as such.
How Much: There are a couple of big issues with these types of inflation hedges, which is one reason it's wise not to go overboard with them. One is that unlike TIPS, they don't reflect the broad basket of goods and services that consumers spend money on. Even the broadest-based commodities-tracking funds obviously won't reflect changes in service categories like healthcare delivery, hair salons, cable TV subscriptions, or gym memberships. REITs reflect inflationary changes in a smaller part of the economy still. Thus, there's a risk that they won't defend against the type of inflation you're experiencing.
Perhaps more important, these investments are quite volatile: If you happen to buy in at the wrong time, as many investors did by racing into commodities following their runup in the mid-2000s, that reduces the inflation-protective benefit that you might derive from them. Of course, the fundamental case for commodities looks better today than it did back then, but commodities have already experienced a significant runup over the past year. I think the bigger issue, though, is that the risk/reward profile of commodities is a mismatch for the problem they're trying to solve. In most periods, inflation is a slow but steady drain on your portfolio's purchasing power, so it seems odd to hedge against it with an investment where you could gain or lose large sums over a short period. Financial planner Jonathan Guyton also points out that investors often replace U.S. or foreign stocks with commodities and may do so at an inopportune time. "If you mistime either buying or selling your hedges," he said, "there can be a real opportunity cost to your portfolio's equity returns." I think it's reasonable for retirees to forgo commodities altogether.
REITs are potentially more interesting for retirees as a long-term allocation, in that their yields are higher than the broad market's. But as Amy Arnott has noted, REIT yields have declined while their correlations with the equity market have increased. The broad market serves as a good baseline when setting your real estate allocation: Total-market U.S. indexes currently have about 3.5% in real estate securities. (That allocation is roughly the same for non-U.S. total-market indexes.)
How They Can Help: What I call "inflation beaters" don't match inflation on a one-for-one basis but rather have a record of delivering returns well above inflation over time. Retirees who are actively drawing from their portfolios need both types of inflation protection--inflation hedges to help preserve their purchasing power and inflation beaters to help their long-term investments grow at a rate in excess of inflation.
Stocks are obviously the top asset class in this category: While near-term return expectations (over the next 10 years) for U.S. stocks are muted in several expert forecasts, over longer periods of time during modern market history stocks have outgained the inflation rate by about 5 to 7 percentage points.
Can certain types of equities do a better job of protecting against inflation than others? Potentially so. Though modern market history provides few truly inflationary periods to examine, companies with a history of increasing their dividends may provide a measure of inflation protection. In contrast with companies whose dividends aren't increasing, dividend-growth companies' payout increases may help them keep up with inflation. The good news for retirees is that such companies are historically higher-quality and less volatile than the broad market, which is a key reason I've emphasized dividend-growth-focused mutual funds and exchange-traded funds in my model "bucket" portfolios.
How Much: I like the idea of retirees "backing into" an appropriate stock allocation, using their anticipated spending from their portfolios to determine how much to hold in safer assets like cash and bonds and in turn how much to hold in stocks. Given that stocks have been reliably positive for holding periods of at least 10 years and more erratic for shorter periods than that, earmarking safe assets for the first 10 years of assets, then holding stocks for spending for years 11 and beyond, is an intuitively appealing setup. For retirees with high risk capacities and/or those who have a high risk of a shortfall, shrinking the allocation to safer assets (and in turn enlarging equity exposure) may make sense.