We are in low unemployment and low inflation. While the punch is still flowing at the party now, you always want to be on the alert for an uptick in inflation. Inflation is your retirement’s biggest enemy.
The good news: some assets help hedge against the impact of rising costs of goods.
What Is Inflation and Why Does It Rise
Inflation is a quantitative measure of how much and how quickly the cost of goods and services increase.
How does it impact you? Purchasing power quickly diminishes during times of rising inflation.
Imagine you left twenty dollars in a drawer in 1970 and forgot about it until 2019. You could have bought 57 gallons of gas at $1.12 a gallon back then, but that $20 bill only gets you 8 gallons. You have inflation to thank for that.
Your investments have to work harder to support the same lifestyle in times of high inflation. If you keep $1000 in CD that yields 2% when inflation is 4%, your inflation-adjusted return is actually -2%.
That’s why it is important to account for inflation when talking about returns by calculating the inflation-adjusted return.
Inflation-Adjusted Return = [(1+Return)/(1+Inflation Rate)]-1
Types of Inflation
Inflation is caused either by high demand or low supply.
Demand-pull inflation occurs when demand for a product or service far exceeds supply. For example, in a strong economy, consumers tend to spend more which also drives prices higher.
Central banks printing a lot of money can also cause inflation because it creates too much money going after limited goods.
Cost-pull inflation occurs when the costs of goods rise. When oil prices are up, for example, the cost for all goods and services that are transported by truck, railroad or ship will rise as well.
A decline in a country’s currency can cause cost-pull inflation too. As the currency loses value, more of it is required to purchase imported goods.
How Inflation is Calculated
The main price index used to measure inflation in the U.S. is the Consumer Price Index (CPI). The Bureau of Labor Statistics (they compile the CPI) polls 23,000 businesses.
The prices of these items are tracked to produce the price index, which is updated monthly.
How to Invest When Inflation Rises
You should revisit your asset allocation when inflation rises because different asset classes react differently.
For example, fixed income investors tend to feel the most pain when inflation marches higher because you have to hold the bond for the duration of the loan at a fixed rate. That could result in less purchasing power if inflation rises. Other assets like real estate and commodities tend to rise with inflation.
Hard assets like investment properties maintain or increase in value when inflation rises.
Investment properties such as rental apartments are a good hedge against inflation because rents increase when inflation does.
Landlords and property owners tend to increase rents in lockstep with increases in the CPI. Even places with restrictive rent control laws such as Berkeley, CA allow landlords to increase rent with CPI. In addition, most commercial leases are linked to CPI by a periodic “step up” mechanism.
High inflation can also result in rising construction costs, which could slow construction, driving demand for rental and existing properties.
REIT Valuations Rise with Inflation
If you don’t want to deal with holding physical property, consider investing in real estate investment trusts (REITs). Their valuations also tend to improve in heightened inflationary periods.
According to Investments & Pensions, REITs outperformed other investment classes in 1996, 2005 and late 2009 when inflation peaked. Meanwhile, the National Association of Real Estate Investments (NAREIT) found that total REITs returns exceeded the inflation rate in six month periods of high inflation.
Whether or not you are concerned about inflation, diversifying your portfolio with some real estate is always a good idea since RE isn’t strongly correlated with stocks and bonds.
Treasury Protected Inflation Assets (TIPS)
A way to directly hedge against inflation is to invest in Treasury Inflation-Protected Securities (TIPS). Backed by the U.S. government, these are Treasury securities’ interest payments and principal value rise with inflation as measured by the CPI.
For example, the average real (that is, after-inflation) yield on TIPS about 0.5% as of March 2019. Should the Federal Reserve hit its 2% inflation target, then the nominal yield will be about 2.5% (2% inflation plus 0.5% real yield).
When the TIPS matures, you’re paid the adjusted principal or original principal, whichever is higher. TIPS pay out interest twice a year at a fixed rate and come in terms of 5, 10 and 30 years.
TIPS have been in the marketplace since 1997 and account for 9% of the Treasury Market or $1.2 trillion. Morningstar covers 55 TIPs, with the funds holding a combined more than $80 billion.
How Do TIPS Work In Inflationary Periods
TIPS protect investors from rising inflation because they adjust when the CPI changes. When the index rises, the principal invested increases but the interest rate remains fixed. When the CPI declines, so does the principal.
According to Morningstar over the past twenty years, TIPS have increased more than inflation as shown in the chart below.
Some investors also worry that TIPS aren’t as riskless as they seem, a hard lesson learned from 2008.low-risk reputation can backfire too. During the financial crisis and the so-called Taper Tantrum of 2013, TIPS declined along with stocks.
In the fall of 2008, TIPS declined 12%. At the same time, nominal Treasuries were able to lodge a small gain.
The reasons for why this happened aren’t clear. Some point to the collapse of Lehman Brothers in September of 2008. Lehman held TIPS and was forced to sell, hurting the prices.
Black swan financial events aside, TIPs are a good instrument for retired investors who want some assurance they can maintain their purchasing power. For investors who are in the accumulation phase, the inflation protection offered by TIPS isn’t worth the fact that they are poor growth instruments.
Commodities such as oil, corn, soybeans, etc. are among conventionally seen the few assets that benefit from inflation.
Commodities keep the world humming along and protect investors in inflationary periods. They’re a leading indicator of inflation for a number of reasons.
- They respond quickly to changes in demand
- Prices are impacted by systemic shocks such as hurricanes or wildfires.
- They have a pass-through effect. When the price of oil rises, for example, it makes the cost to produce and transport goods pricer. That expense is passed on to the consumer.
Why Commodities Are a Good Bet When Inflation is Rising
Commodities have faced a challenging few years as the stock market and the economy continued the bull run. But with the likelihood of rising inflation on the horizon, commodities should do better if history is any evidence.
Gold Versus Inflation
When it comes to commodities to hedge inflation gold has long been seen as the crown jewel. Over the last 50 years, gold has tended to perform better as a hedge against heightened inflation, particularly in the late 1970s and early 1980s when oil prices were skyrocketing. The inflation-adjusted gold price back then was more than able to keep up, even when inflation rose to close to 15%.
Hedging Against Inflation with Commodities
- Buy and warehouse physical commodities directly
- Invest in a commodity-focused mutual fund
- Purchase a commodity-focused ETF
- Invests in companies that produce commodities
How Commodities Perform Against Inflation
When stocks are doing well, commodities tend to suffer. PIMCO found from 1970 through 2015 the Bloomberg Commodity Index had low correlation with U.S. equities in the S&P 500 Index and zero correlation with global bonds as benchmarked by the Barclays Global Aggregate Index. But commodities were positively correlated with the CPI during that time frame.
Annuities To Hedge Against Inflation
Annuities are commonly used by retirees. To addition to paying out a steady income, inflation-protected annuities provide protection against rising inflation.
Inflation-protected annuities can be fixed or variable. With a fixed inflation-protected annuity the payment increases at a fixed percentage each year. With a variable inflation-protected annuity, the payment increases with the CPI.
Inflation annuities are designed to protect against inflation and longevity risks. With retirement easily lasting twenty to thirty years the money and its purchasing power have to last.
There is a downside for the added protection against inflation. They tend to cost more. According to a recent U.S. News report, a 65-year-old male who purchases a $100,000 annuity with a 3% cost of living increase each year thereafter, will pay $137,089.
You have to weigh the benefits over the long-term with the upfront costs. You do get steady payments that protect against inflation but you could get higher returns elsewhere.
How Annuities Perform Against Inflation
Annuities aren’t going to make you rich. A study Advantage Compendium found from 2007 through 2012, the average annual return for fixed indexed annuities was just 3.27%. The high-end average annualized rate of return was 5.5%. The low end was 1.2%.
In comparison, the Vanguard Total Bond Market Index had an average annualized return of 6.5%. Fixed annuities did do better than the Vanguard Total Stock Market Index Fund.
If inflation ever does pick up, you need to be prepared. Thankfully you have plenty of options.
If you’re looking for protection and a chance for higher returns, real estate (preferably, investment properties over REITs) wins out over the rest. It tends to increase in value when inflation is rising, making it an attractive hedge against what is inevitable.