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The Best Inflation-Fighting Investments for Retirement Portfolios

In-retirement portfolio allocations should include a blend of inflation hedges and inflation beaters.

This article previously appeared on Dec. 27, 2021.

In a 2019 Society of Actuaries survey, pre-retirees and retirees were asked about the issues that worried them most about their money in retirement.

Topping the worry list for pre-retirees? That the value of their investments might not keep up with inflation. Nearly two thirds of pre-retirees cited inflation as a key worry—tied for the top slot with concerns about long-term-care expenses and ahead of worries about higher healthcare costs.

While inflation averaged less than 2.0% between 2011 and 2020 and it was 1.4% in 2020, those pre-retirees were ahead of the curve. Inflation jumped sharply, with the Consumer Price Index peaking at 9.1% in June 2022.

The Federal Reserve has taken an aggressive approach to curb inflation by pursuing multiple rate hikes in 2022. While it appears that the high inflation we've seen thus far may be subsiding, pre-retirees and retirees should still take steps to protect their plans against inflation. They can make sure they're factoring in their own situations and spending patterns when deciding how big a deal inflation is for them. Inflation should also play a role in how they think about taking withdrawals from their portfolios. Finally, retirees can confront inflation with their portfolio holdings to ensure that the purchasing power of their investments isn't gobbled up by higher prices over time.

When thinking about how to inflation-protect a portfolio, I think it's useful to segment those inflation-fighting investments into three key groups:

  1. Broad inflation hedges.
  2. Narrower inflation hedges.
  3. Inflation beaters.

What I call "inflation beaters" are investments that don't track inflation directly but that have historically outreturned inflation by a healthy margin over time. We tend to need the hedges more when we're older than when we're younger, while investors of all ages need their investments to beat inflation—at a minimum.

Here's a closer look at how these categories have worked to mitigate inflation risk, as well as reasonable retirement portfolio allocations to these groups.

How Broad Inflation Hedges Can Help Your Retirement Portfolio

Inflation hedges are investments whose values go up when higher inflation comes on line. These investments can be further subdivided into two groups: those that aim to reflect inflation broadly, as measured by the Consumer Price Index, and those that reflect higher prices in a smaller basket, such as commodities or real estate.

In the former group, Treasury Inflation-Protected Securities and I Bonds both help the value of their investors' accounts keep pace with the Consumer Price Index for All Urban Consumers, or CPI-U.

From a practical standpoint, many investors opt for TIPS mutual funds for simplicity and ease of use. Moreover, I Bonds have severe purchase constraints that limit their effectiveness for larger investors who are aiming to build a significant bulwark against inflation.

How to Find the Right Portfolio Allocation to Broad Inflation Hedges

Because they offer inflation protection, principal protection, and government backing, TIPS seem like the ideal asset for retirement, but TIPS' return potential is constrained by still-low bond yields. And in contrast with nominal U.S. Treasury bonds, the TIPS market has sometimes seized up in equity market shocks; TIPS haven't been as reliable as ballast for equities as Treasuries or cash have been. TIPS are also sensitive to changes in interest rates; the fact that TIPS funds are in the red this year is a clear illustration. That makes it important to match TIPS investments to your anticipated spending horizon. Short-term TIPS products will make sense for spending horizons of less than five years, while intermediate-term TIPS are more appropriate for longer time horizons.

So, what's the right amount to hold in TIPS in retirement? Most professional portfolio allocations geared toward people in retirement steer anywhere from 10% to 25% of their fixed-income allocations into TIPS. How to allocate within that range? Consider a couple of factors: how much inflation is impacting you personally (based on your customized inflation rate) as well as how much of your retirement income you're drawing from your portfolio. If the answer is "a lot" on both counts, then it makes sense to be at the high end of that range. If you're not feeling a big inflationary pinch and/or nonportfolio income sources like Social Security provide most of your income needs (Social Security itself is inflation-adjusted), then the lower end of the range makes sense.

How More Narrowly Focused Inflation Hedges Can Help Your Retirement Portfolio

Another category of inflation hedges reflects price changes in narrower slices of the economy, either directly or indirectly. Commodities-tracking investments are the best example in this category: They aim to reflect price changes in items like basic materials, energy products, and agricultural products, which in turn affect the prices we pay for a lot of our basic needs.

Other inflation hedges in this group are narrower still. For example, real estate investment trusts have fared reasonably well as inflation hedges. That's because the owners of the apartment and office buildings, shopping malls, and hotels in REIT portfolios are often pushing through rent increases at times when inflation is running up, which in turn enhances REIT payouts and security prices.

Contrary to conventional wisdom, gold hasn't been a particularly effective inflation hedge, even though it's often cited as such.

How to Find the Right Retirement Portfolio Allocation to Narrower Inflation Hedges

There are a couple of big issues with these types of inflation hedges, which is one reason it's wise not to go overboard with them. One is that, unlike TIPS, they don't reflect the broad basket of goods and services that consumers spend money on. Even the broadest-based commodities-tracking funds obviously won't reflect changes in service categories like healthcare delivery, hair salons, cable TV subscriptions, or gym memberships. REITs reflect inflationary changes in a smaller part of the economy still. Thus, there's a risk that they won't defend against the type of inflation you're experiencing.

Perhaps more important, these investments are quite volatile: If you happen to buy in at the wrong time, as many investors did by racing into commodities following their runup in the mid-2000s, that reduces the inflation-protective benefit that you might derive from them. Of course, the fundamental case for commodities looks better today than it did back then, but commodities have already experienced a significant runup over the past year.

The bigger issue, though, is that the risk/reward profile of commodities is a mismatch for the problem they're trying to solve. In most periods, inflation is a slow but steady drain on your portfolio's purchasing power, so it seems odd to hedge against it with an investment where you could gain or lose large sums over a short period. Financial planner Jonathan Guyton also points out that investors often replace U.S. or foreign stocks with commodities and may do so at an inopportune time. "If you mistime either buying or selling your hedges," he said, "there can be a real opportunity cost to your portfolio's equity returns."

I think it's reasonable for retirees to forgo commodities altogether.

REITs are potentially more interesting for retirees as a long-term allocation, in that their yields are higher than the broad market's. But as Amy Arnott has noted, REIT yields have declined while their correlations with the equity market have increased. The broad market serves as a good baseline when setting your real estate allocation: Total-market U.S. indexes currently have about 3% in real estate securities.

How 'Inflation Beaters' Can Help Your Retirement Portfolio

What I call "inflation beaters" don't match inflation on a one-for-one basis but rather have a record of delivering returns well above inflation over time. Retirees who are actively drawing from their portfolios need both types of inflation protection—inflation hedges to help preserve their purchasing power and inflation beaters to help their long-term investments grow at a rate in excess of inflation.

Stocks are obviously the top asset class in this category: While near-term return expectations (over the next 10 years) for U.S. stocks are muted in several expert forecasts, over longer periods of time during modern market history, stocks have outgained the inflation rate by about 5 to 7 percentage points.

Can certain types of equities do a better job of protecting against inflation than others? Potentially so. Although modern market history provides few truly inflationary periods to examine, companies with a history of increasing their dividends may provide a measure of inflation protection. In contrast with companies whose dividends aren't increasing, dividend-growth companies' payout increases may help them keep up with inflation. The good news for retirees is that such companies are historically higher-quality and less volatile than the broad market, which is a key reason I've emphasized dividend-growth-focused mutual funds and exchange-traded funds in my model Bucket portfolios.

How to Find the Right Retirement Portfolio Allocation to Inflation Beaters

I like the idea of retirees "backing into" an appropriate stock allocation, using their anticipated spending from their portfolios to determine how much to hold in safer assets like cash and bonds and in turn how much to hold in stocks. Given that stocks have been reliably positive for holding periods of at least 10 years and more erratic for shorter periods than that, earmarking safe assets for the first 10 years of assets, then holding stocks for spending for years 11 and beyond, is an intuitively appealing setup. For retirees with high risk capacities and/or those who have a high risk of a shortfall, shrinking the allocation to safer assets (and in turn enlarging equity exposure) may make sense.

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