We have all heard grandparents talk about the “good old days,” when a gallon of gas only cost a quarter and you could buy candy for a penny. How times change. In just the last half-century, the price of living has risen an average of 3.8% each year.*
What is Inflation?
The general increase in prices for goods and services in a country is called inflation. The rate of inflation, measured in an annual percentage, varies from year to year. Inflation of some kind should always be expected and planned for.
While you are working, inflation may not pose a huge problem to you. Wages tend to keep up with the rate of inflation; therefore, you may not feel as much of a sting when prices begin to rise. However, inflation can cause large problems for retirees on a fixed income. As you plan for retirement, it is crucial to take inflation into account.
The Risk of “Playing It Safe” (i.e. Bonds, TIPS, Cash, Annuities)
Because of inflation, the “purchasing power” of a dollar falls over time. This means that your cash will purchase less in ten years than it will today. Unless the interest rate of your bank account is higher than the rate of inflation, the purchasing power of your savings will decrease over time.
In addition, low-risk investments like bonds can also be impacted by inflation. While bonds seemingly guarantee a certain rate of return, they are denominated in nominal terms, so the purchasing power of a bond actually decreases when the rate of inflation is greater than the nominal return of the bond.
For example, if a bond has a nominal return of 3% and the inflation rate is 4%, the real return of the bond is -1%. Because the return of the bond does not rise with the rate of inflation, the purchasing power of the bond actually decreases. Thus, in most cases, “safe” investments like bills and bonds will not protect you against long-term inflation. A famous example comes from 1946, in the aftermath of WWII when the US government, saddled with debt from the war, drove inflation to over 18% to make the debt easier to pay off. As a result, holders of US war bonds realized a negative inflation-adjusted return on those bonds.
TIPS, or Treasury inflation-protected securities, are a type of US government bond that is protected against inflation. Their returns are linked to the CPI (Consumer Price Index) and therefore their value will rise as inflation rises. Be cautious, though, as TIPS have very low yields when inflation is low. In the past ten years, TIPS have actually under-performed similar short-term assets.
So, although you may be tempted to “play it safe” by investing only in short-term bonds, cash equivalents, or annuities, we encourage current and future retirees to invest at least 40% of their portfolio in diversified equity.
Your Greatest Ally Against Inflation – Equities
Equity assets, like stocks, which many people consider to be higher-risk assets, actually provide a hedge against the long-run risk of inflation. Stocks outpace the rate of inflation over the long-run. When prices rise across the market, companies raise their prices accordingly. The process can be messy across individual companies, but this means that by owning stock in a large number of them, the value of your stock holdings will automatically adjust to inflation, preserving the value of your nest egg in the event of another year like 1946.
Although investing in equities cannot guarantee complete protection against short-term periods of inflation, stocks still tend to outperform low-risk investments like bonds during these times. Thus, those retired or approaching retirement must not yield to the temptation to get too “conservative,” because in doing so they’re becoming more vulnerable to periods of high inflation. 30-40% of diversified equity should be the minimum equity allocation for the standard retiree investment portfolio.
Deciding how to invest for retirement can be simple when you meet with a fee-only financial adviser. A true financial advocate can help you discern your unique situation and create a balanced portfolio that will provide protection against inflation and other investment risks. Visit our website to learn more about our Investment Management Services, or contact us today to talk with an advisor.
* Federal Reserve Bank of St. Louis, 1960-2016: Inflation, consumer prices for the United States, Percent, Annual, Not Seasonally Adjusted