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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.

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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.”

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Inflation Riders

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

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.

I-Bonds

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.

Their latest report on the industry, published Sept. 27, reveals that between 1974 and the first quarter of 2011, REITs had positive total returns in 10 out of the 14 inflationary periods within that span.

And, during the six periods when inflation rose, REITs had an average annualized return of 10.7 percent, compared with 9.8 percent for stocks and 4.6 percent for bonds.

“U.S. REITs have outperformed stocks and bonds in periods of both rising and moderating inflation,” Cheigh and Bohjalian write, noting such securities have proven to be an “effective inflation hedge.” “In our view, this will hold true as the next cycle takes shape.”

Blue-Chip Stocks

Retirees looking to insulate their income against the effect of rising prices should continue to keep a portion of their portfolio invested in stocks—specifically, dividend-paying blue chips.

While higher on the risk scale than TIPS and other fixed-income securities, stocks are the only asset class that give you a fighting chanceof outrunning inflation.

“While not a direct hedge against inflation, if you’re looking for investments with the potential to outstrip inflation over time, or earn a better return over time, stocks have to be part of your portfolio,” says Morningstar's Benz.

Jeffrey Hirsch, president of the Stock Trader’s Almanac, agrees.

His latest book calls out a handful of top blue chip picks, those that have consistently increased their dividend for at least the last 10 years.

Among them: IBM, Abbott Laboratories, Nucor, McDonald’s, Pepsico and Wal-Mart Stores.

Several mutual funds, including Morningstar’s top pick Vanguard Dividend Growth Fund, do the screening for you—investing exclusively in companies with a history of dividend growth.

I-Bonds

Lastly, I-Bonds, or inflation-linked U.S. savings bonds, are another option for your inflation-fighting toolkit.

Interest on I-Bonds is paid in two ways—as both a fixed interest rate, set when you purchase the bond, and a variable rate, which changes twice a year based on the CPI.

Because the interest earned is paid out when you sell, however, you won’t collect an income stream during the years you own it. You won’t have to pay tax on the interest as it accrues either, of course, which is why Benz of Morningstar says I-Bonds are safe to hold in a taxable account outside of one’s retirement portfolio.

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One downside: Investors are restricted to $10,000 per year per person, a drawback for large investors looking to use I-Bonds for inflation-fighting purposes.

For retirees, inflation can be an insidious thief.

An appropriate allocation to inflation fighting tools like TIPS, REITs, I-Bonds, and stocks can help ensure your savings keep pace with the cost of living.