By now, if you’ve been paying attention, you know the many reasons that explain the sudden surge in inflation. What you don’t know—what nobody knows—is whether this surge will sustain itself for the long term or whether it will evaporate just as quickly as it came about.
Maybe you don’t need to know that answer. Maybe what you should know is what makes inflation a problem and how you should prepare your retirement savings to defend against it.
Inflation is the silent asset killer. It eats away at your hard-earned savings, often in a stealthy manner that you hardly notice. It even masks itself behind misleading good news in your investment returns that may not be as good as you think.
“Most investors seek to earn at least a real rate of return on their savings,” says John P. Micklitsch, Chief Investment Officer at Ancora in Cleveland. “By ‘real,’ we mean a return in excess of inflation. In a sense, inflation therefore becomes the return hurdle that forces investors to take risk, be it in the fixed income market or, more commonly, through the equity market. The cumulative ‘real return’ earned over one’s lifetime is what eventually pays for the things we cannot necessarily afford today such as retiring, college educations, weddings, etc. Therefore, higher inflation makes obtaining future financial goals potentially more difficult.”
Don’t believe you’ll develop a herd immunity to inflation once you retire. No. With 30 or more years spent in retirement, those thousands of dollars you had when you retired might only be worth hundreds of dollars if you live long enough.
Unless you’re as rich as Croesus, because of inflation you’ll have to continue to invest for growth even when you’re retired.
“Retirees need to have a financial plan based on income generation,” says Mike Windle, CEO at Custom Wealth Solutions in Plymouth, Michigan. “This plan needs to include an annual increase in income based on inflation. To offset the expected increase in inflation, retirees need to have a growth component built into their retirement portfolio. This could be a portfolio of investment securities like mutual funds, ETFs, or individual stocks, or it could be a fixed indexed annuity or even an indexed based structured note.”
If that sounds complicated, it shouldn’t be. For some time now, portfolio managers have known which assets offer the best inflation hedge. They also know what doesn’t work. With just this general knowledge, you can begin to insulate your portfolio against the potential damage inflation can cause.
“Inflation reduces the future spending power of cash, so retirement savers need to invest cash in various assets to compensate for future inflation,” says Steven Saunders, Director, Portfolio Advisor with Round Table Wealth Management in New York City. “Diversified portfolios are an attractive way to guard against surprise inflation as there is generally an allocation to areas like equities or real estate that typically performs well when inflation increases. Currently, a portfolio of just Treasury bonds and cash does not provide the required return to compensate for inflation so it is important for savers to understand inflation and how it impacts their investment strategy.”
Bonds can be especially tricky as rising inflation usually presages rising interest rates. That’s generally not ideal for bond holders.
“Typical retirement savers when it comes to 401(k)s don’t account for inflation,” says Derek S. Taddei, Relationship Manager, 401(k) Specialist at HoyleCohen, LLC in Phoenix. He finds this to be the case particularly for “those who decide to stay in money market funds because it is generally safe. They are expecting a 7% return on something that is returning below 1% in many cases. There are many strategies to hedge against inflation, one of those strategies would be to better manage, or avoid longer dated bonds, because if inflation pushes up longer-term bond yields, most longer dated bonds will lose money. Make sure you have the right allocation between growth and value, domestic and international stocks, as adjusting the stock allocation to sectors and industries positively impacted by inflation can be an opportunity.”
There are two aspects of bonds which can be troublesome during inflationary times. First, inflation erodes the real value of the fixed income generated by those bonds. Second, as Taddei mentions, the rising interest rates that accompany higher inflation causes the bond price to drop.
Now, if you hold the bond to maturity, price fluctuation is less of an issue for you. The hundred dollar par value that you originally invested in the bond is returned to you in whole when the bond matures. Still, thanks to inflation, that hundred dollars will buy less than it did when you bought the bond.
If you want to see how incredibly easy it is to fight inflation, just take a look at what happened in real time over the last several generations.
“If you are saving for retirement and are concerned about inflation, there may be no better place to look than ensuring you have a healthy allocation to equities,” says Mike Cocco, Equitable
EQH
Advisor at Equitable in Nutley, New Jersey. “In 1960, the S&P 500 was 58; and now it’s above 4,200—70 times higher. Also, dividends have increased 30x over that same time span. The Consumer Price Index ended 1960 just under 30; last month it came in at 267—only nine times higher. So, looking back, if you wanted to give advice to that 30-year-old in 1960 on how to grow their assets on a real-return (inflation-adjusted) basis multiple times over, they needed to be largely invested in equities.”
By the way, you’ve probably heard one of those charming radio or TV ads that proclaim the wonders of commodities—in particular, precious metals like gold—as a faithful inflation hedge. Sadly, this is not the case.
“For those who may have heard gold is the best way to navigate high inflation, looking at 1980 to present, the Dow Jones Industrial Average and the price of Gold were both at 800,” says Cocco. “Today, gold is shy of $1,800 while the Dow Jones is over 34,000. The thing to remember is that inflation happens because prices and wages are rising, and this is largely a good thing for the economy, because ideally this means that businesses are doing well, unemployment is low, people have jobs and are spending a lot of money. If you are an investor, you must be willing to take on investment risk to keep pace with inflation.”
Don’t be afraid of inflation. Take a strong stand against it.
But abide by this word of warning: keep it simple, lest you fall prey to common inflation fighting mistakes.