Retirees: How Inflation-Tough Is Your Portfolio and Plan?

Susan Dziubinski: Hi, I'm Susan Dziubinski for Morningstar. Consumers are seeing signs of inflation, which might strike fear into the hearts of some retirees who lived through the very high inflation rates of the 1970s and 1980s. Joining me to discuss how to assess how inflation-tough your retirement portfolio and plan are is Christine Benz. Christine is Morningstar's director of personal finance.

Hi, Christine. Thank you for being here today.

Christine Benz: Hi, Susan. It's great to see you.

Dziubinski: How big of a concern is inflation right now? Should we start worrying?

Benz: Well, there have certainly been some worrisome headlines. We had a much higher inflation reading for the month of April than was expected, and I think that has some consumers worried. We've seen the market appear to be a little bit worried about inflation. We've seen bond yields ticking up. The big thing that economists seem really puzzled by is that they are not sure whether this is just a short-term phenomenon associated with the reopening of the economy with fuller vaccinations, the pent-up demand that is out there, and whether it will go back to more-normal levels going forward. So, I would say it's very much in the category of "watch this space." I don't think it's a hair-on-fire, worry-about-inflation moment just yet. But certainly, we all have gotten very accustomed to inflation being very, very low. It may not always be the case. I think it's worth keeping on your dashboard, especially if you are someone who is retired and in part living on your portfolio.

Dziubinski: If a retiree is concerned about inflation, how can he or she go about sussing out how big of a threat it might be for them?

Benz: It's a really good question. I would say take a close look at your spending. The tricky part is that spending over the past year was pretty anomalous relative to what it's likely to be in the years ahead, because we had so much constraint in terms of what we could do in terms of travel and restaurants and all the things that constitute quality of life, especially in retirement. But do start taking stock of your spending, think about the categories where the biggest parts of your budget go. The good news for retirees is that some of the categories where we've been seeing high inflation lately do not affect them as much as the general population. So, energy prices we've seen have been going higher. Retirees in aggregate tend not to spend as much on energy. They tend to not be commuting, for one thing, and so that's less of a drag on their budgets. On the other hand, healthcare inflation, at least historically, has been running higher than the general inflation rate. That's a category where retirees do tend to spend more than the general population. So, spend some time looking back on your spending over the past year or two, think about the categories where you're spending, and take a look at whether the inflation is trending up or down in those areas. The Bureau of Labor Statistics does publish a really nice granular view of where inflation has been heading, up or down. Compare that to your own spending categories.

Dziubinski: But you think it's also important to take a look at your in-retirement income sources, specifically looking to find out if any of them offer you some inflation protection or an ability to keep up with inflation.

Benz: Yeah, I think that's such a valuable exercise. And I really think of retirees as being on a spectrum here. So, in sort of the perfect inflation-hedged category would be a retiree who is lucky enough to retire with a full pension that's providing most of his or her income needs or all of his or her income needs and is inflation-adjusted. The problem is such pensions are really pretty rare today, mostly just in the public sector do we see those sorts of pensions. But that's someone who is sort of perfectly protected against inflation.

At the other end of the spectrum would be someone who is relying exclusively on his or her portfolio to meet income needs in retirement and they're hunkered down in very safe investments that don't provide any insulation against inflation. That person is very, very vulnerable to inflation. Most of us will land somewhere between those two poles. For most retirees, they're getting a portion of their income needs from Social Security, which is inflation-adjusted, but they are also pulling additional living expenses from their portfolio, which is not inherently inflation-adjusted. So, take stock of that. See where you fall on that spectrum.

Dziubinski: Christine, what about at the portfolio level? Let's say someone is tapping into that portfolio as a retiree for retirement income. Are there particular asset classes that will do a better job of helping insulate them against inflation?

Benz: Definitely. When we think of fixed-income assets, your best ally there is to use some sort of Treasury Inflation-Protected Securities. Professionally managed asset allocations from, say, our colleagues at Morningstar Investment Management, would typically include 20% to 30% of the fixed-income portfolio in Treasury Inflation-Protected Securities for people who are retired. And then, you might think of some ancillary fixed-income assets around the margins of your fixed-income portfolio, so high-yield bonds or bank loans, for example. That's the fixed-income piece.

On the equity side, I think a key thing to keep in mind is that, even though equities are not a hedge against inflation--so if inflation goes up 3%, your equity portfolio won't necessarily go up 3%, too--equities have historically generated better returns than inflation. And that's one reason why I would argue that retirees, even conservative ones, should maintain ample exposure to stocks in their portfolios even in retirement, because that does provide some cushion against inflation.

Dziubinski: And you've been a little bit less enthusiastic traditionally about some of the categories that investors might think of when it comes to inflation protection, like real estate or commodities. Why is that?

Benz: Well, a couple of reasons. One is that it's really hard to get the timing right on these assets. You might maintain ongoing positions in them, but investors sometimes give up on them at the worst possible time. So, that is a key reason. And the other thing with commodities is just they're extraordinarily volatile. And so, even though they have tended to be pretty positively correlated with inflation, many investors just have a hard time sticking with them. Those would be a few of the key reasons that I would be less optimistic about including those categories.

Another thing to keep in mind is that they are not as encompassing as CPI. So, real estate investments have historically had some correlation with inflation, some utility as inflation hedges, but they're really just encompassing a narrow segment of the market. So, they are not as broad-based as, say, the inflation adjustment that you would receive with a Treasury Inflation-Protected Security.

Dziubinski: And then, lastly, Christine, what about the idea of adding inflation protection if you are someone who's purchasing an insurance product. So, what if you have an option to add a rider for your long-term-care policy? Is this something that investors should be thinking about in retirement?

Benz: Well, it certainly sounds attractive, especially as we're all more worried about inflation. The key thing I would keep in mind, though, is that the pricing for the inflation protection tends to swing around a little bit. We were recently interviewing an expert on annuities for our podcast, and his point was just that the inflation protection for annuities had just gone through the roof in terms of adding it, that it was prohibitively expensive, and that retirees might reasonably just sort of accept that risk because the price of adding that inflation insulation was just extremely high. So, we will tend to see that variability. Unfortunately, you'll tend to see the pricing on such features go higher when inflation is very much top of mind for consumers as it is today. So, it will ebb and flow. Right now, my fear is that such inflation protection is pretty expensive.

Dziubinski: Christine, thank you so much for your perspective today. We appreciate it.

Benz: Thank you, Susan.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.