When Inflation Meets Your Financial Plan
With some planning and awareness, you can steer your retirement fund safely through times of inflation.
Christine Benz: Hi, I'm Christine Benz from Morningstar. We haven't seen much inflation over the past decade, but we've been recently hearing more about it. Joining me to share his perspective on what higher inflation might mean for your financial and your retirement plan is Jonathan Guyton. He is Principal at Cornerstone Wealth Advisors.
Jon, thank you so much for being here.
Jonathan Guyton: Nice to be here. Thank you.
Benz: Well, it's great to have you here. First of all, I'd like to get your perspective on how worried you are about inflation, and perhaps you can also share your thoughts on what you are hearing from clients about inflation, whether they are worried about inflation perhaps ticking up.
Guyton: Well, it's been in the news, like you said. Frankly, we are not all that worried right now for a couple of reasons. Number one, it seems like the economy is just beginning to reflate from somewhat of a decline in prices. So, we are keeping our eye on where price levels go relative to where they were before the pandemic began. And then, the second thing is, it would really take this showing up in some sustained wage increases before this would be the kind of embedded longer-term inflation that really could have some impact.
Benz: One thing that we've been hearing is that this environment is maybe sort of comparable to the financial crisis. Coming out of the financial crisis in 2009-2010, there was a lot of handwringing about inflation during that period. It didn't really materialize. Do you think that that's a good comparison or not so much?
Guyton: Yeah, we have been supposed to have had a lot of inflation from various things over the last couple of decades, and it really has never come to pass. If you look back at the Great Recession, a couple of things seemed different. First of all, the Great Recession was accompanied by the collapse in the housing market and a lot of people's houses went underwater, there were foreclosures. It was a real shell-shock to literally millions of American homeowners that seemed to impact their spending decisions. The second thing is that the response by Congress, the stimulus act that was passed, two of them actually that were passed back in 2009 and 2010, were not anywhere as large as what was done this time. I'm not sure that Congress actually is doing better economics this time, but I think that the combined things of right now that we've seen in the last year have made it possible for spending to by and large continue, that people have money to do things like that. So, I think that this particular time will be more effective at keeping the economy from having such a long time to respond and get back to where it was. And that, of course, is what brings the question of, well, you know, have we put too much punch in the punch bowl and made the party a little too fun?
Benz: Right, right. That's the question. A related question. When we think about inflation and you think about your clients, do you get more worried about inflation for retired clients than you do for clients who are still working and eligible for those cost-of-living adjustments? How does life stage affect how you approach factoring in inflation into the financial plan?
Guyton: Sure, because you're right. The cost of living does continue to rise when you are retired. For most retirees, they fund a decent percentage of their ongoing core living expenses through Social Security once they get to a point where they decided to claim. And of course, that income is fully indexed to inflation. I think your colleague, David Blanchett, did some significant research on this a couple of years ago, where he demonstrated that over the course of retirement, the spending level of retirees, while it does continue to go up, it does not go up as quickly as the overall rate of inflation. So, in a strange way, at least over the long run, inflation is not as big a concern in aggregate for retirees, but it certainly might be for some, for many retirees, who right now are wanting to travel or they still are able to lead an active lifestyle. But by and large, with where we are right now, it shouldn't be a concern.
Benz: How about healthcare expenses for retirees? You mentioned how their trajectory of spending kind of changes throughout our retirement lifecycle. How does retirement spending, healthcare spending, and inflation and healthcare spending affect your thinking?
Guyton: You're right that healthcare inflation is higher. If you go back, I did a little checking in preparation for our conversation, if you just look at Medicare Part B premiums, over the last five years, they've risen about 4% per year, not always 4% every year, but that's the average, and that's about double what we've seen in the underlying inflation rate. So, it is there. But for most retirees who are on Medicare, where they really see a big jump is when something happens to their health and they are triggering more copays or a bigger use of deductibles, rather than the inching up every year of what those costs are. We've said for our clients pretty well the last several years that if you are planning to spend $500 to $600 a month per person on your overall healthcare, that would be between your Medicare Part B premium, what you are doing for prescriptions, copays, deductibles, out of pocket, that that should pretty well cover you, and that amount does need to go up a little bit every year. But remember, when David Blanchett did that work and said the overall level does not keep up with inflation, that is including the effect that some areas like healthcare may actually be rising greater than inflation. So, as long as you have a good plan and you know where your spending is on that, you should be okay.
Benz: Okay. And how about the complexion of the investment portfolio? What sorts of investments do you include in clients' portfolios, I guess, thinking specifically about retired clients' portfolios to help defend against inflation?
Guyton: Well, when you are looking at a portfolio and you are asking it to provide you with sustainable income, the key is that the portfolio's overall return is high enough to support the withdrawals that you need to take out over that period of time. So, in periods of moderate inflation, the typical mix works pretty well. I mean, stocks do well. They have the highest positive real returns when it comes to that of returns above inflation. But if we were to see inflation getting up into the 5% to 6% per year level, that's an environment where stocks have had difficulty.
Now, it's certainly true that there are periods of time where specific inflation-protected investments like commodities, for instance, or precious metals have really shone. They have really outperformed other equities. But you have to get the timing right, because whenever you add more of something like that to your portfolio, you are taking something else away. You are putting less money, for instance, into U.S. equities or international equities or what have you. And so, unless--historically, those more inflation-protector equities have not done as well as the equity market. So, unless you get your timing right when you go in and when you back out, you are probably going to come out on the short end of the stick with that.
Benz: How about investments that might specifically defend against inflation, things like Treasury Inflation-Protected Securities? You referenced some of the more-narrow inflation protectors that people might use, things like commodities. Can you talk about how you think about those positions and what sort of percentages you use in terms of allocations?
Guyton: Sure. Well, you did a piece just within the last couple of months, Christine, on this, which was really quite comprehensive. So, I'm kind of just repeating some of the things that you mentioned. But certainly, the Inflation-Protected Treasuries, TIPS as they are known, you can buy them individually, you can buy exchange-traded funds. There are short-term and longer-term TIPS just like there are shorter-term and longer-term Treasuries. So, there's all kinds of tools that people can use. Historically, when we've seen higher and sustained inflation, you've gotten a little better returns from those. Remember that TIPS do well when inflation expectations and inflation is rising, and they do not do well when interest rates are rising, but inflation expectations are not. So, normally, those two happen at the same time, but they are not always happening at the same time. So, just be careful of that.
In terms of percentages, it certainly would be appropriate if someone wanted to allocate maybe a quarter of their fixed-income holding in that direction. The other defense that that will give you is that generally it's U.S. government securities that hold up the best when equities decline in value. And if inflation heats up to the point where you get some kind of a sell-off in the stock market, it's going to be really important that your bonds hold up because you may need to draw on them for a period of time while you are waiting for the equities to recover. So, because TIPS are U.S. government securities, they should help in that regard, although they don't tend to hold up as well. For instance, a year ago, when the pandemic really hit with full force, TIPS suffered, whereas the straight Treasuries did not for at least a period of time. But that's a good place to start with that.
And then, like we said earlier, you can certainly choose to replace some of your other more maybe traditional equities with some type of a commodity ETF or even precious metals. But again, remember that's a choice and that will either have a positive or a negative impact based on the timing that you deploy.
Benz: How about the withdrawal rate? You have conducted a lot of research on withdrawal rates, and you've had a lot of experience managing client portfolios with respect to withdrawal rates. So, how should people think about inflation potentially impacting their withdrawal rates? If they think inflation is going to go higher, should they be more conservative with withdrawals? Can you talk about that interplay?
Guyton: Sure. Well, there is a lot of research that's been done, as you know, around sustainability of withdrawals, and there are lots of ways that that research was done, and it all included periods of time where inflation was far higher than we've seen today. And I think it's important for retirees who are aware of that and are essentially relying on some kind of an evidence-based approach to know that the evidence they are relying on took into account periods like this. Now, it's true that the higher inflation is, the higher the amount of money you are going to be taking out every year unless you have some other adjustment mechanism that you are following. And so, that means that you have to keep an eye on things. You have to be sure that the plan you are following is one you still have confidence in, and you have to keep an eye on it to the extent of knowing where that withdrawal rate is.
A withdrawal rate can go up for two reasons. One is the amount you are taking out is going up quickly, or the amount of the underlying investment pool is going down. Both of those will make that percentage go up. And so, by keeping an eye on that withdrawal rate--and once a year is enough. It doesn't change all that much throughout the year in general terms. But you can do it as often as you want. At our firm, we meet with our clients every six months, and we are monitoring those withdrawal rates every three to six months. So, as long as you see what's going on with that kind of the temperature of that, you can then make adjustments based on the underlying plan that you have. However, if the underlying plan you are following or the method that you are using really doesn't have a good explanation for how to handle a period of higher inflation, then maybe you want to evaluate the underlying plan itself and make some changes before you get into some deeper water.
Benz: Okay, Jon, great perspective. Thank you so much for being here.
Guyton: Happy to do it.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.