Addressing Inflation in Retirement
My last post discussed my biggest retirement fear; the fear that the US will experience persistent high inflation at a rate much greater than the return on my retirement assets. In this post I will discuss several ways that retirees can try to mitigate this risk.
Inflation is a bigger problem for retirees than for younger people who are still working. In an inflationary environment people still employed will experience increasing salaries as well as higher prices. Retirees, on the other hand, tend to have more income that is of a fixed nature.
The inflation rate does not have to be very high to have a corrosive effect on purchasing power. For the last 30 years inflation in the US has averaged about 3% per year. At 3% inflation per year retirees living on $50,000 per year will need 34% more income, or $67,000 per year, 10 years later to maintain the same purchasing power. After 20 years, a retiree would need 80% more income, or $90,000 per year, to maintain the same purchasing power. What if inflation averages 5% per year for 20 years? In that case $50,000 per year would have to increase to $133,000 per year to maintain the same purchasing power.
If you have a fixed annuity corporate pension as part of your retirement income, this payment will be worth less and less every year. If you have a lot of fixed income investments such as bonds, these will also lose buying power over time. What is a retiree to do? Below are a few ideas that you might consider incorporating into your investments to help offset the effects of inflation.
Inflation-adjusted Treasury Bonds
The federal government sells two types of treasury bonds that increase with inflation each year. They are Treasury Inflation Protected Securities (TIPS) and I-Bonds. These bonds have a fixed coupon at issue and each year (twice a year for I-bonds) the bond principle increases by the Consumer Price Index (CPI). This method of applying inflation increases to the underlying bond value means these debt instruments are best suited for retirement accounts.
The only problem I have with these government issued debt instruments is the inflation adjustment is determined by the same party that has to pay the higher interest (i.e., the federal government). There is a conflict of interest in this arrangement. Over the last 30 years the government has already changed the CPI calculation a couple times. Each time the calculation has been changed to understate the real inflation rate. The CPI affects many government programs such as social security and federal retirement pensions. I believe the government will continue to manipulate the CPI in the future to lower their entitlement payments. So TIPS and I-bonds are not my preferred method to combat inflation.
Immediate Annuities with Inflation Rider
Immediate annuities are insurance contracts purchased with a single lump sum that offer immediate income payments for a specified period of time or for the annuitant’s lifetime. Most immediate annuities do not increase with inflation. But some insurance companies have been adding products that do have an inflation rider. The trade-off is that the immediate annuity with an inflation rider starts out with a lower initial payout. Vanguard’s website has a service that lets you compare income annuities from leading insurance companies.
If you decide you need more inflation protection as well as certainty in your retirement income, I think it is best to buy an immediate income annuity with few, if any, other features. Insurance products with lots of flexible features come at a price. Usually, that price is your initial payout is lower.
Be sure to thoroughly research any annuity products you are considering. Once you enter into an annuity contract with an insurance company, you cannot undo the contract. You will lose access to the lump sum payment you forked over to the insurance company. Unless you have an unusual situation most retirement planning experts recommend keeping any annuity purchases to no more than 30% to 40% of your total retirement assets to be sure you maintain your liquidity.
Cash Assets
If the country’s response to high inflation is the same as it was in the 1970s and early 1980s, then cash assets could actually do well. When I say cash assets, I mean any fixed income asset that has a short duration of say 2 years or less. The reason cash assets did well in the late 1970s and early 1980s is because the Federal Reserve kept aggressively increasing interest rates as inflation increased. At that time if you had short-term bonds or bank CDs maturing, you could re-invest them at higher and higher interest rates. By late 1981 it was possible to buy a 10-year treasury bond with a 13% coupon. Inflation peaked at about 14% in 1981 and then decreased every year thereafter, so a 13% 10-year bond did pretty well in the 1980s.
The only problem with this approach is today’s economic environment is very different from 35 years ago. In the 1970s the US government and the average US citizen was not overburdened with debt the way they are today. A rapid and significant increase in interest rates today will cause a lot of pain for consumers and the federal government as well as slow down the economy. I am not confident that today’s Federal Reserve will quickly move to increase interest rates to combat inflation the way they did in the late 1970s.
Delay Social Security
One of the best ways to address the risk of inflation is to delay the start of your Social Security income until age 70. This will give you the highest possible, inflation-adjusted, guaranteed stream of income possible from Social Security.
My full social security retirement age is 66 years old. The way social security is currently constituted, my social security benefit will increase 8% per year for each year I delay collecting social security from age 62 until 70. This annual 8% increase does not include inflation adjustments. If the CPI averages 3% per year after my 62nd birthday, my social security benefit would increase 11% per year until age 70. That is probably the best low risk annual return available today. So I will delay collecting social security until age 70.
Invest in Equities
Stocks allow some inflation protection, but most stocks do not do well if inflation becomes very high as it did in the late 1970s. This is due to labor and material input costs increasing as well as higher borrowing costs. However some stocks will do better than others in an inflationary environment. Usually health care, utilities, and consumer staples stocks do okay as these defensive companies sell things that people will buy no matter what the economic environment.
I currently own a lot of large-cap defensive stocks (e.g., JNJ, PG, MDT, D, KFT, WMT, etc.) that dominate their industries, have very little debt, and pay a healthy dividend. I like these stocks because they have a history of increasing their dividends over time helping to offset inflation. However, investing in commons stocks means that you sometimes trade inflation risk for investment risk as the stock prices could experience a lot of volatility. In my case I am holding these stocks for income and don’t plan on selling them. In any event, during times of high US dollar inflation, I would restrict my stock allocation to established companies with pricing power and international operations that will allow some currency diversification.
Precious Metals and Commodities
Precious metals and commodities often rise in value during periods of long-term inflation. I have provided my thoughts on why I think people should own gold and silver in this previous post. Personally, I think the developed world’s indebtedness and any future inflation that arises from this indebtedness will cause gold and silver bullion to be the best inflation hedge. But precious metals do fluctuate widely in the short term so you dollar cost average your purchases in precious metals over time.
Commodities (wheat, cotton, coffee, etc.) and natural resources (oil, iron ore, copper, etc.) are more economically sensitive. High inflation may ultimately depress the economy if consumer buying power declines causing the demand for commodities and natural resources to decline. So I would be careful investing too much in these areas. But I do think commodities and natural resources will do well in the long term due to the growing middle class in the emerging economies.
Real Estate
One final area that will provide some inflation protection is real estate. But the protection will not be in the same manner as in years past. Real estate increased at an average rate of about 5%-6% per year from 1980 until 2005. This increase was higher than the average inflation rate of about 3% per year.
I think real estate prices in the future will likely decrease in value on an inflation adjusted basis due to the likelihood of higher interest rates. However, if you do not plan to sell your home, this should not matter. But an increase in market price is not the only way that a retiree’s home can help fight inflation. If your personal residence is paid off or is financed with a fixed rate loan, your housing cost is mostly fixed. Your property taxes, insurance, and utility costs may increase, but you do not have to worry about lease or loan payments increasing. If you are a renter, you can be sure your lease payments will increase every year. As such, in a high inflation environment, it is better to be a landlord than a renter. Therefore, income from rental properties will provide a very good inflation hedge even if property values do not.
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