Time to Read: 9 Minutes
As the U.S. economy continues to recover from the Covid-19 induced shutdown in 2020 amid record government stimulus from both Congress and the Federal Reserve, many high-net-worth clients are becoming more concerned about the prospects for much higher inflation in the United States. It has been several decades since the U.S. last experienced sustained inflation. What does it mean for the economy as whole, and how does it affect individual investors? Particularly for retired investors, ensuring a portfolio continues to meet income and growth goals can be a challenge in an inflationary environment. We’ve created a short primer around inflation and how investors can protect their portfolios and revise their financial plans to keep them on track.
What is inflation?
Inflation is always a key topic in many financial discussions and this year is no exception. With the Federal government stimulus legislated by Congress, along with monetary stimulus from the Federal Reserve, over $7 trillion has been funneled into the economy since early last year, fueling speculation that we will have higher inflation in the years to come. Before discussing inflation in more detail, let us first define what inflation means and how it is measured.
Inflation is a general increase in prices and decrease in the purchasing value of money over time. If you have purchased a car recently, bought groceries, or paid a recent utility bill, it is hard not to recognize that prices are on the rise. The U.S. Bureau of Labor Statistics (BLS) tracks the rate of inflation through a measurement called the Consumer Price Index (CPI). The CPI measures the change in prices paid by consumers for goods and services. The components of the CPI index include food, energy, clothing, shelter, health care services, and other goods and services that people buy for day-to-day living. Another significant measurement of inflation is calculated by the U.S. Bureau of Economic Analysis (BEA). Personal consumption expenditures (PCE) is the value of the goods and services purchased by, or on the behalf of, people who reside in the United States. Although both measurements are similar, they are uniquely different. The CPI is based on a survey of what households are buying; the PCE is based on surveys of what businesses are selling.
What are the causes of inflation?
An increase in the supply of money is one of the greatest factors. Additionally, prices can rise because there are not enough products or services being produced to keep up with demand. Alternatively, when costs to produce products and services rise, businesses are forced to raise prices. Finally, organic income growth can cause prices to rise as businesses must raise prices to account for higher labor costs. Also, demographics can play into higher inflation; when an economy has a small working age population relative to the rest of the population, inflation pressures tend to be greater; scarcity of workers bids up the price of labor, driving wages upward.
Is inflation good or bad?
Inflation is typically categorized as negative for the overall economy for a variety of reasons. However, inflation is viewed as positive when the rate of inflation is moderate, as it helps boost consumer demand and consumption, driving economic growth. When the economy is not operating at full capacity, inflation can help increase production. Inflation usually occurs when the supply of money is greater than the demand for money. When the supply of money increases, consumers have more dollars to spend which creates more demand, which requires more production to meet that demand. Some also believe that inflation is meant to keep deflation (when prices fall) in check. If consumers believe prices will rise in the future, they are more likely to spend today rather than risk paying more tomorrow. If people feel that prices will decline in the future, they will wait to make purchases which creates a slow-down in production and overall economic activity.
The Federal Reserve has set a target rate of 2% average inflation, but if it were to rise significantly over that level it could negatively impact the economy, as high inflation can further decrease purchasing power for consumers. Also, if people expect prices to rise in the future, they will buy larger quantities of goods today, with the expectation they will somewhat insulate themselves from higher prices. However, this behavior drives inflation even higher, as companies are less efficient and must shift production from other areas to meet demand.
How can I protect my portfolio from inflation?
In general, if your investments are not producing a return more than the current inflation rate, you are losing money. For example, if you purchase a 30 yr Treasury bond at 2.50%, but over time the inflation rate increases to 3%, your “real” rate of return is a negative (.50%). So, in general, purchasing “fixed” assets that pay the same income each year can be detrimental during periods of high inflation. Investors will sell these types of assets in high inflation environments pushing their prices down. However, inflation can cause many investments to rise in value.
What investments do well during inflation?
Real estate typically performs well as property values can increase and landlords can raise rental rates over time to help offset higher prices. Commodities like gold, oil, copper, wheat, etc. can also perform well because most commodities are priced in dollars, and when high inflation occurs it weakens the currency. As the dollar falls, commodities become cheaper relative to other currencies that are trading stronger versus the dollar. As such, demand increases at lower prices, and prices increase, making commodities a good inflation hedge. Unlike real estate however, commodities do not pay income, so their prices can be volatile in periods of rising interest rates where rising bond yields compete against investments which do not pay income.
Inflation-indexed bonds can perform well during inflationary environments. Commonly known as TIPS, Treasury Inflation-Protected Securities, which are pegged to the CPI, can perform well in periods of higher inflation. Also, riskier bonds, like high-yield debt can perform well. Leveraged loans can also hold up well because these instruments possess “floating” interest rates, meaning the income they pay is pegged to short-term interest rates. As the Federal Reserve raises the Fed Funds rate to combat inflation, the yield on leveraged loans rises in tandem with LIBOR or Fed Funds. Structured credit investments can also perform well. These investments are typically mortgage-backed securities, or asset-backed securities and other structures that are based on consumer loans. Finally, equities can still perform well during inflationary periods, provided the increase in the rate of inflation is moderate and not extreme.
Don’t forget your 401(k) and other qualified plans.
Americans hold a significant portion of their net worth in qualified retirement plans. The average 401k balance was $109,600 in Q3 2020. 401k plans held around $6.5 trillion in assets as of September 30, 2020. For many Americans, the 401(k) is their primary retirement savings vehicle. High net worth investors oftentimes have additional retirement plan options, including defined benefit plans. Investors must not forget to review their investment allocation during inflationary environments, given the important role these assets play in providing for retirement income. As the investment options in a plan, and the information available on them may be limited, it can be difficult to create an asset allocation that will help to adjust to inflationary pressure. At BWM, we can stress test outside accounts like 401(k)’s and other retirement plans to ensure that the investment allocation is resilient in a higher inflation environment and provide guidance on how to modify an allocation to protect your portfolio.
Factoring inflation into financial planning?
“When can I retire” is the most common question financial advisors are asked. One of the key inputs to any proper financial analysis is the assumed inflation rate. The greater the inflation rate, the less purchasing power you will have in retirement. Given we haven’t seen a high inflationary environment since the 1970’s, it is very important that multiple planning scenarios are compiled to determine how an increase in inflation could impact your plan, and the team at BWM is ready to help. If it turns out that a modest, but long-term, structural increase in inflation does materialize it could impact the date at which one can retire. Of course, there are other tradeoffs to ensure the plan is still successful: you can save more, spend less, take more risk with investments, and target a higher rate of return, but if these tradeoffs are not feasible, the possibility exists that one will need to work longer to ensure a stable retirement income for life.
The pre-retirement savings rate is the first step to ensuring your retirement happens on a schedule you set. At BWM, we routinely work with clients to determine the optimal rate when factoring in a rising inflation rate scenario. As inflation rises, savings rates may need to increase due to a lower “real” rate of return in your portfolio. If inflation cuts into your investment return and real rates of return decline, then oftentimes, savings must be increased to make up the difference. All these scenarios can be stress tested using our software tools to give clients peace of mind that their plan is still on track.
Risk management – long-term care/life and disability insurance.
Risk management is foundational to any successful financial plan and insurance plays a vital role in protecting clients from unforeseen events. During periods of higher inflation, insurance premiums typically rise since the insurance company must pay higher replacement costs for labor and raw materials when paying off other claims. With life insurance, policies do not adjust the death benefit for inflation. Therefore, if inflation is increasing it may make sense to purchase slightly more coverage to compensate for the potential reduced purchasing power of the policy’s death benefit.
About 70% of Americans over the age of 65 will need long-term care (LTC) services during their lifetime. In 2020, this number was expected to exceed 12 million. Over the next 20 years, the number of Americans aged 65 and older will more than double to 71 million, comprising roughly 20% of the U.S. population. Given these statistics, clients must invest the time to decide if transferring some of the potential LTC expense makes sense and most LTC policies offer an inflation rider. For example, policy holders can choose either simple interest, or compound interest, as their inflation rider. Oftentimes this rider offers up to 3% to 5% in yearly inflation protection.
With a simple interest inflation rider, the future benefit payments can be increased by 3% each year, but only on the original payment in the first year of the policy. The compound interest rider levies the 3% increase on the previous years’ benefit, so you essentially get interest on top of interest. Many high-net worth clients consider “hybrid” policies which also feature inflation protection, but typically require a large upfront premium of over $100,000. The advantage to clients is they not only insure against the risk of LTC expenses, but also protect their families against the rising costs of health care with the inflation rider.
At BWM we typically model several LTC scenarios in a client’s financial plan to help them choose the best insurance solution, or simply self-insure. Disability policies also offer methods to protect from higher inflation. By purchasing a cost-of-living adjustment (COLA) rider, this will increase the monthly benefit paid to you while you are claiming disability insurance benefits, pegged to the CPI or other cost measurement. The benefit only begins to increase while you are claiming benefits.
The bottom line.
In summary, inflation can significantly impact our lives, now and in the future. It’s necessary to take each piece of a holistic financial plan into account, and factor in both the potential positives and negatives of an inflationary environment.. At BWM we are passionate about helping our clients live their best life, and we are ready to serve your family should you need any assistance.