Shopping for Inflation Hedges
With inflation still looming as an economic wild card, investors are taking a closer look at asset classes that traditionally outperform as consumer prices rise.
None more so than retirees.
Without a salary, or new sources of income, inflation can hit the senior set (who invest heavily in fixed-income securities) especially hard, eroding both purchasing power and their standard of living.
“The inflation rate for seniors is always higher because of health-care costs, which make up a bigger portion of their budget, and have risen by about 5.4 percent a year over the last 30 years,” says Matt Schott, vice president of retirement income practice for the Financial Research Corp. in Boston.
Of late, the consumer price index,CPI, which tracks the price of goods and services, has been all over the board.
After its most recent peak of 5.6 percent in July 2009, it plunged to negative territory (2.1 percent) a year later. And it’s been trending higher ever since, thanks to the rising cost of food and fuel—hovering today at around 3.8 percent.
While many economists say inflation is not a near-term threat in the U.S.,indirect pressure could cause the price of household staples (such as milk and clothes) to continue to rise, says Christine Benz, director of personal finance for mutual fund tracker Morningstar.
“The emerging markets are still growing robustly, and that’ll fuel demand for products here,” she says. “So while the threat of inflation is not necessarily high here, investors should still prepare for what could be a scenario where we’ve got slow growth but higher prices.”
The Case for TIPS
Commodities, particularly gold and energy stocks, have long been viewed as traditional inflation hedges, since they tend to outperform in an inflationary cycle.
And, indeed, both have given rock-star performances over the last few years, but they can also be volatile.
As such, Anthony Webb, research economist for the Center for Retirement Research in Boston, says they are ill-suited for retirees.
Those in the decumulation phase of their retirement planning, he says, should consider other tools to insulate their income against the threat of inflation.
Among them: TIPS
Though their yields are currently flirting with all-time lows, Treasury Inflation-Protected Securitieshave been hugely popular among retirees since the economic downturn began—due largely to the flight toward safe-haven securities.
Such government-issued bonds, which are exempt from state and local tax, pay out a regular fixed-rate interest payment, but the principal is adjusted to reflect changes in the Consumer Price Index.
Because you’ll owe federal taxes on the interest income, they are best held in tax-sheltered retirement accounts, says Benz of Morningstar.
Despite their low yields, Benz suggests retirees devote anywhere from 10 percent to 30 percent of their fixed income portfolio to TIPS, noting it’s best to dollar-cost average into the position rather than buying it as a lump sum.
“There has been a stampede into Treasurys and, as a result, many people think their yields are just too low,” says Benz. “I agree that that’s a concern, which is why I would urge anyone initiating a sizable investment to do it gradually over time to obtain a variety of different purchase prices and mitigate the risk of buying at a high point.”
Retirees also may wish to incorporate an inflation-adjustment feature to their annuities or long-term care insurance policies.
Such policies cost more, says Benz, but are well worth the investment, since they help to insulate future purchasing power.
“Given that folks buying an annuity could live a good 20 or 25 years in retirement, inflation could substantially decrease the value of the annuity’s payouts over time,” she says. “The same holds true for long-term care insurance.”
The typical buyer, Benz notes, purchases a policy while in his or her late 50s or early 60s, but may not actually use the policy for another 20 or 25 years.
By then, the cost of long-term care could have ramped up dramatically.
“Long-term care costs, like health-care costs, have been running much higher than the Consumer Price Index, CPI, for years and it’s hard to imagine that trend abating any time soon,” she says.
Real estate investment trusts(REITs), which invest primarily in commercial real estate, can also help hedge against inflation, since property owners have the ability to raise their rents to keep pace with higher prices, says Webb.
REITs, which are sold as shares on the major stock exchanges, are often touted as an affordable way to gain exposure to income producing properties without sacrificing liquidity.
Because they are required to distribute at least 90 percent of their taxable income to shareholders annually, they also provide a steady income stream in the form of dividends.
Historically, REITs have been less volatile than commodities, but the recent financial crisis, in which real estate suffered mightily, changed all that.
After a jaw-dropping 34 percent climb in 2006, the NAREIT All REIT index lost nearly 18 percent in 2007 and another 37 percent in 2008, before surging back with a 27 percent return in both 2009 and 2010.
So far this year, the index is up roughly 3 percent.
Despite the ups and downs, Jon Cheigh, and Tom Bohjalian, portfolio managers for New York-based asset management firm Cohen & Steers, suggest that REITs remain an important component of the well-balanced portfolio.