How Financial Advisors Are Protecting Retirees From Inflation

Best Practices April 14, 2021 at 04:17 PM
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The increasing fear of rising inflation has some pundits discussing  — and advisors wondering — what options are available for retirees to protect their nest eggs in case the inevitable happens.

In a recent column, Christine Benz, director of personal finance for Morningstar, pointed out that the large amounts of fiscal stimulus and a resurgent economy are fodder for worries about renewed inflation. She writes that "the so-called break-even rate — the differential between what nominal 10-year Treasury bonds and Treasury Inflation-Protected Securities yield — recently shot up to 2.3%."

That break-even rate, which she says is viewed as a proxy for market inflation expectations, is "nearly 2 percentage points higher than it was a year earlier, when pandemic worries pointed to a sustained economic slowdown."

She notes that this isn't always the case, but baby boomers now in or nearing retirement recall the 1970s, when inflation jumped over 7%, and the '80s, when it rose more than 5%.

How is an advisor to prepare client portfolios if this happens? Benz reviews a few choices. We also asked advisors through the Financial Planning Association to provide their client solutions to the potential of inflation.

1. Broad Basket Inflation Hedges

These are hedges that fall into two groups, Benz explains. The first are Treasury inflation-protected securities, or TIPS, that help client portfolios keep pace with the Consumer Price Index. If the CPI goes up, the TIPS owner "receives an increase in his/her principal value. If inflation goes down, the principal goes down, too. "

The I-bond works similarly; however, TIPS holders have semiannual interest payments, while I-bond holders "receive accrued interest when their bond matures or they redeem it."

Benz notes that TIPS mutual funds are easier to use than I-bonds, which "have severe purchase constraints that limit their effectiveness for larger investors who are aiming to build a significant bulwark against inflation."

Because returns on these products can be low, Benz notes that in-retirement allocations should range from 10% to 25%, depending on the inflation pinch to the portfolio.

TIPS are one method used by Matt Bacon, of Carmichael Hill & Associates in Gaithersburg, Maryland. "We're adding TIPS, floating rate funds and some low duration funds back to fixed income portfolio," he told ThinkAdvisor in an email.

TIPS bonds are also used by Rob Greenman, of Vista Capital Partners in Portland, Oregon. These bonds "are a nice inflation hedge to include in portfolios," he said in an email. "Unlike most other bonds … the principal value of TIPS changes periodically to keep pace with inflation. As a result, for the life of a TIPS bond, investors are guaranteed their investment will keep up with inflation."

2. More Narrowly Focused Inflation Hedges

These hedges include commodities-tracking investments and aim to reflect price changes in items such as basic materials that affect consumer prices, Benz says.

Real estate investment trusts, which have "fared reasonably well," also fall into this category, she says.

Gold hasn't been particularly effective as an inflation hedge, Benz states.

She recommends that clients not go overboard on these products, because they don't reflect a large segment of the economy. Further, they can be volatile. "If you happen to buy in at the wrong time … that reduces the inflation-protective benefit that you might derive from them."

REITs might be better for retirees for a long-term allocation, as the yield can be higher than that of the broad market. But that isn't always the case, and allocations should be limited.

In addition to adding TIPs, Bacon says that "we're continuing to hold positions in real estate, gold and dividend paying equities on inflation expectations."

3. Inflation Beaters

These are products that beat inflation, and are typically stocks, Benz says. Although stock returns have muted forecasts over the next 10 years, she says, "over longer periods of time during modern market history, stocks have outgained the inflation rate by about 5 to 7 percentage points."

Dividend-growth stocks, and those companies that are historically higher in quality and less volatile than the broad market, are best, she says. It's a key reason she emphasizes dividend-growth-focused mutual funds and ETFs in her model portfolios. She also advises "backing into" the amount to allocate to a retirement portfolio based on anticipated spending.

Equities are an important inflation hedge, notes Marisa Bradbury of Sigma Investment Counselors in Lake Mary, Florida. "Specifically, investments in sectors that can pass price increases on to customers. When you're paying $10 more to fill up your gas tank each week, it helps to look at energy stocks and see they've gone up substantially."

A traditional stock and bond portfolio is "still the way to go," opines Anthony Watson of Thrive Retirement Specialists in Dearborn, Michigan. "Stocks have historically been an excellent hedge against inflation. Inflation does cause an issue for bonds as [it] brings on higher interest rates, [which] decrease the value of bonds," he says. "Keeping the portfolio's bond side at a lower-than-normal duration level would be warranted to lessen the negative effect on bond values."

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