At a friend’s BBQ the other day, I was approached by a soon-to be-retiree. Normally, I get cornered at social gatherings by folks looking for a hot stock tip or my thoughts on cryptocurrency. This gentleman, however, came with a much different intention. He wished to discuss his current predicament, a strong concern about inflation and how it will impact his ability to retire.
Since 2008, inflation has stayed at 3% or less annually and has not been a point of apprehension for most investors. Over the past 12 months ended in April 2021, the Consumer Price Index, an average measurement of what consumers pay for everyday goods and services, jumped by 4.2%. While this increase was alarming to many, it is especially concerning to those who are approaching retirement and need their savings to last the remainder of their life.
Only time will tell if inflation will prove to be a real concern in the coming years. The key for retirees is to plan ahead. Below are some proactive strategies to consider to prepare for an inflationary environment.
1. Delay claiming Social Security: If you are in good health and don’t currently need the cash flow, holding off on claiming Social Security is a smart strategy to mitigate the impact of inflation. Today, Full Retirement Age (FRA) for a retiree to get their full benefit is 66. One can claim Social Security as early as age 62, but anything before FRA comes with a reduction in benefits up to 30%. Conversely, Social Security will add an additional 8% delayed retirement credit to your monthly payout for each year, up until age 70, if you hold off on claiming the benefits. That’s a guaranteed annual return of 8% for deferral after your FRA.
Social Security has the added benefit of a cost of living adjustment (COLA), which has averaged about 1.5% a year over the past ten years. The COLA increases may not be usually enough to keep up with inflation. Nevertheless, there are not many forms of guaranteed income in retirement planning that also adjust for the increasing cost of living. It’s important to sit down with your financial advisor to determine the proper Social Security withdrawal strategy to accommodate your own situation.
2. Purchase items that you will need in retirement, today: This may not be possible for everything needed in retirement, but it is a practical strategy for some projects or goods. If you were planning to do construction on your home when you retire to accommodate possible lifestyle changes, for example building a master suite on the first floor with a handicap accessible bathroom, then getting a jump start now may be sensible. Waiting several years until you actually retire may result in significantly increased costs of renovations due to high inflation. Similarly, if you know that you will be downsizing, then consider doing so sooner rather than later before housing prices increase further.
The same strategy can be applied to leisure items you anticipate using frequently in retirement. This may include golf clubs, a boat, an RV, purchasing new skis, or putting in a hot tub. It’s impossible to predict what products will experience higher price inflation, but by planning ahead and getting what you need today you will have fewer inflationary concerns to worry about in retirement.
3. Position your portfolio to withstand inflation pressures: If you don’t want to outlive your funds, it’s imperative to structure your portfolio to outpace inflation. Some considerations include:
Overall allocation: The returns on stocks tend to outperform the pace of inflation over an extended period of time. For example, from 1972 through 2021, inflation has averaged about 3.8% per year. The total US stock market has grown at over 10.8% annualized over the same time frame. Investors with a multidecade retirement should consider allocating a sufficient portion of their portfolio to stocks even in retirement to ensure that they are able to maintain their buying power after inflation. It’s important to work with your financial advisor to develop an allocation that is prudent not only for inflation, but also for your overall specific situation.
Real estate: Investing in real estate, either in physical property or publicly traded Real Estate Investment Trusts (REITs), tends to serve as a good protection against inflation. Owners of real estate will receive income payments through rents and leases that are often higher yielding than bonds. Owners also have the potential to increase rents over time and the properties themselves may also appreciate in value. These characteristics make for a natural cushion again inflation.
Treasury inflation-protected securities (TIPS): TIPS increase in value in order to keep up with inflation. The value of these bonds are linked to the Consumer Price Index (CPI) and their principal amount is reset according to changes in this index. Therefore, if CPI continues to rise at an above average pace, so will your investment in TIPs. It may be worth considering an allocation to TIPS as part of your investment grade fixed income allocation.
Floating Rate Notes: Floating rate notes are a type of bond whose yield can fluctuate over time just like the rate on a savings account. Their rate is determined by another rate that moves over time such as U.S. Treasury notes, the Federal Reserve funds rate, or the London Interbank Offered Rate (LIBOR). If inflation begins to shoot higher, the Fed may attempt to get it under control by raising rates. This will hurt traditional bonds, whose price has an inverse relationship to the movement of interest rates. However, floating rate notes will reset and may increase in value to account for a higher Federal Funds rate.
One of the obvious risks of floating rate notes is that their yield will fall if interest rates fall. However, if you have a strong conviction that inflation will spike and stay elevated for a meaningful amount of time, then carving out some exposure to floating rate securities may be worth considering.
Investing internationally: Inflation does not necessarily impact countries around the world in the same way at the same times. As a recent example, Venezuela’s hyperinflation hit 10 million percent from 2018 to 2019. In the US, inflation over the same time period was only 2.3%. While this is an extreme example, with many factors at play, it does illustrate that different countries experience inflationary environments, and other types of risks, at different times. Allocating a portion of your portfolio to investments outside of your home country is prudent and worth considering regardless of which risk presents itself.
There are various other vehicles that folks in the investment community have promoted as good hedges against inflation such as commodities, cryptocurrency, or other speculative asset classes. The performance of many of those is primarily driven by supply and demand rather than a stream of cash flows. Personally, I have stayed away from these products, but it behooves all investors to seek guidance from their investment professionals to develop a strategy that is conducive to achieving their goals.
4. Work longer: This strategy is undoubtedly the least popular, but it’s also the most effective. For those folks who are still able to work, there is nothing that will serve as a better hedge against inflation.
Working longer in your current job, or consulting part time, allows soon-to-be retirees to delay spending down their nest egg. Instead they can use their income from employment to continue to maintain their lifestyle. This strategy requires one’s savings to last for a shorter period of time. If you retire at age 70 instead of 65, that’s five fewer years that your assets need to last, which is significant. It also gives one’s investments additional time to grow. Using the same example of someone who pushed off retirement for five years, their $2 million portfolio at age 65, growing at a modest rate of 4% a year, would result in an additional $430,000 for when they retire at 70 if they don’t need to dip into this money. That’s a nice additional chunk of savings to absorb the effects of rising inflation.
Not everyone is able to continue working for health, family, or other reasons, but for those who can, it may be the closest one can get to a silver bullet to address all their inflation concerns.
Disclaimer: This article authored by Jonathan Shenkman a financial advisor at Oppenheimer & Co. Inc.
OPY