Investment Tips for Retirees Worried About Inflation

As I was getting coffee in the faculty lounge, I started talking to a senior colleague who is nearing retirement. He said that he avoided a lot of the market pain of the last year because he had only about 25 percent of his savings in stock. (Now with the market drop, he has an even smaller percentage!) But his current concern is inflation.

As this killer graph from Paul Krugman shows, Ben Bernanke has been incredibly aggressive in expanding the money supply.

It is quite reasonable to be worried that the Fed will not be nimble enough to suck up this cash as the economy recovers. The banks and others are currently hoarding cash. But when they start to spend or invest it, the Fed will need to remove it by buying back assets (such as Treasury bonds), or we will have substantial inflation.

So here’s a puzzle: What should you do if you are retired or close to retirement and you are scared about the risk of inflation?

Holding stocks is often a way to hedge inflation — because dividends and stock prices rise with inflation. But at this stage in your life, you don’t want the risk of holding stock. Where should you invest at least some of your money to hedge the inflation risk?

This is not a hard puzzler; but if you’re having trouble, here’s a hint: Larry Summers.

A less obscure hint is the title of this post.

I’d love to hear your suggestions (let me say in advance that speculating on gold is not a great answer).

But the most simple response is to buy TIPS. TIPS stands for Treasury Inflation Protected Securities:

TIPS are treasury notes which offer guaranteed payments — interests in every six months and principal on security maturing. In every six months, the value of TIPS is automatically recalculated with respect to the inflation rate (measured based on Consumer Price Index, CPI). That is, when the inflation rate is up, the value of TIPS is also increased automatically.

I mentioned Larry Summers because Summers championed their creation when he was Deputy Treasury Secretary in the 1990’s. I think of TIPS as Summers’s gift to the world, giving us a low-risk way to hedge inflation risk.

The brilliant Andy Tobias also points out that TIPS hedge not only against inflation, they also provide a hedge against deflation — because in comparison to stocks they will keep their value, even if there is a decline in the Consumer Price Index.


Joe Smith

I went looking to see what TIPS are trading at but could not immediately find it. That said my recollection is that they were recently trading at real returns below 2%. If you believe that real risk free rates are headed up then someone buying a long term TIPS in todays market is locking in a low rate of return and as a result is risking a capital loss if they have to sell. It should also go without saying that these instruments belong only in tax deferred accounts like 401(k)s

John Brennan

You state that the Fed will by bonds to squelch inflation. Isn't the opposite true?

Ahem

Except that TIPS suck.

Not only did they not track inflation fully during recent inflationary increases but the way they work for taxes leaves you paying taxes on virtual gains in value during increasing inflation, even though you don't actually collect this increase.

If you had TIPS during the most recent inflationary period (the only one where you could have held TIPS), you would have underperformed inflation and almost everything else while paying taxes for nonexistant gains that you couldn't realize.

PaulD

Mr Ayres,

As a non-economist I would appreciate your response to what Ahem has posted. Thanks for a great blog.

ToJoe

Joe, you actually have it backward. TIPS inflation is not locked like the coupon on a bond as the face resets according to the CPI. So your observation actually means that TIPS are very cheap right now relative to treasuries. If inflation were to rise at all, you would get the inflation component essentially for free.

The only problem with TIPS right now is that the holder has no interest rate protection nor getting any yield on coupons.

Nick

TIPS may "suck", as any nominal gains one has are taxed even though they broke even or lost money in real terms. However the same could be said for holding money in the stock market. I think the point of the blog was to point at a very secure vehicle for preserving ones retirement. TIPS might yield no return, or even a slight loss, however you hedge yourself from the risks incumbent in the stock market.

Noumenon

Ahem is right about the way TIPS work for taxes, but all of the bonds I own go in my IRA anyway so the taxes don't matter for me. Bond interest is too highly taxed to keep them in taxable accounts. I suppose if you're gonna have 75% in bonds, you can't do that, but most people don't recommend keeping that much.

KB

Sure, TIPS are one option for people to consider. But there is also something to be said for placing one's assets into a variable annuity and add a living benefit to the contract. This way, the client is is still fully invested in the market - thus addressing the inflation issue - and then you also have the ability for unlimited growth. And If the market tanks, the client will be protected with a guaranteed income stream.

This is an alternative that allows the client to stay in the market!

Mercutio.Mont

Seems to me that it may be better to go with short term (12 month or less) CD accounts.

It's FDIC insured, you make some money even if there's no inflation, and if there is inflation then the next time you renew your CD you will be paid a higher interest rate.

Now, if one is literally only concerned about inflation, then TIPS would make more sense than a CD account, probably. But with CDs you get the chance to make a little extra money without going outside of the government insured bubble.

I'm not a financial expert or anything, so please don't use this "strategy" based on my advice. It's just idle speculation.

Captain Obviousness

Inflation is not the only concern - the wholesale collapse of the dollar is not out of the question. We have budget and trade deficits that are only growing bigger, not to mention social security liabilities in the future. If the ROW figures out we can't pay our national debt, watch out, any dollar denominated asset will lose most of its value, and that includes TIPS. Open bank accounts in countries who responsibly manage their currency, like Switzerland or Australia. Buy precious metals. Short term corporate bonds may be a good source of income for now, but be ready to get out when the you know what hits the fan.

Imad Qureshi

I agree with #2. I think you wanted to say the opposite.
Quote:
"But when they start to spend or invest it, the Fed will need to remove it by buying back assets (such as Treasury bonds),"

I think it should be "selling Treasury bonds".

odograph

Isn't the liquidity added still small compared to all the equity that got "disappeared" in the housing, stock, and bond crashes?

Bloomberg says "Investors bought the dollar to purchase Treasuries and shield their money from credit-related losses and stock declines that wiped out more than $28 trillion from equity markets."

For me to worry about inflation in real goods i have to worry that more money will somehow come around to compete for those real goods. Well, there's $28 Trillion that won't.

Patrick

You haven't priced in the risk that the CPI is more doctored than Frankenstein, or that the treasuries game is the biggest ponzi scheme in history.

brianmc

i do investment education for a living (obvious disclosure--if for some reason my identity/employer's identity becomes known, my views are not those held by my employer). i'm still quite the amateur when it comes to things like stock picking, options trades, and derivatives. but taking these goals into account, let me see what we've got to work with:

1) kb is totally right about a variable annuity. it's entire purpose is to adjust for inflation. however, it does often come with fees and lower returns than are available through other methods. you have the trade-off of convenience (aunnuitize and forget it) for potential gains.

2) intermediate government bonds work nicely for some inflation protection. even though they are taxed as income (perfect for retirement accounts?), if you buy at the right times, they can work very nicely. ginnie maes in particular can pay a pretty good yield when it comes to safety of principal. for that, you have a huge increase in interest rate risk.

3) i recognize part of the challenge is to avoid market risk. so instead of common stock, you can buy preferred stock. you give up the preferred status in liquidation (which is why you buy super-high ranked companies) in exchange for more inflation protection.

4) short term CDs really don't offer much in terms of inflation risk. they're great for money that you need in a short period of time, but you generally want to align your asset allocation with when you need the money.

5) it's always good to have some common stock but rebalance periodically. if you maintain old, large cap companies that pay periodic dividends, you can keep something like 15% of your portfolio in risk appropriate stocks.

the recent volatility has led many to believe stocks are simply too volatile for those close to retirement or already there. what it really should mean is that you should assess your risk appropriately, consider things like market, reinvestment, interest rate, inflation, and diversification risks. the person who was all in nasdaq stocks can see his balance sheet and know the risk. the person all in money market funds only watches his purchasing power dwindle through time.

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Andrew

yeah, the fed can contract the money supply by selling treasury bonds. They do this indirectly by raising interest rates, which entice people to buy more treasury bonds.

TIPS are alright in theory, but the problem is how inflation gets calculated. I am wary of it. The government, who is facing alot of future payments of money, would love to see inflation so those payments are easier to handle.

Jai

Mr. Ayres,

You are not qualified to give people investment advice. TIPS are horrible. Either we get inflation and the treasury yield falls or we get deflation and the treasury yield climbs, both cancel each other out.

TIPS are useless, just diversify your money into wide range of currencies and buy gold and silver. You won't make a huge amount of money but you won't lose it. Mr. Ayres specializes in repeating the typical Wall Street advice that has led to this mess.

Mr. Ayres, how would you feel if your advice caused hard working people to lose thier savings? Why don't you post your 401K statements to show us that at least you have some sort of clue?

Joe Hill

I am with #2 and #11. I was aware that the Fed would have to sell those securities in order to hold those dollars and keep them out of the hands of consumers and intermediaries. Isn't this right? Also, due to the new monetary policy tools that the Fed has used, a lot of the assets on their balance sheet don't have many ready and willing buyers (or so i am told). If this is true, can anyone tell me specifically what assets they are talking about? Thanks in advance.

Jay

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brianmc

from 16: [Why don't you post your 401K statements to show us that at least you have some sort of clue?]

this is a charming idea, but has no bearing on qualifications or ability to give advice. investments should be tailored to the individual, not a general prescription for the world at large.

if you truly believe that someone with the need for current income should invest in the same securities as someone who needs long-term growth, then i'd be delighted to know why.

ETA @ 7:

if you're concerned about how bonds are taxed, you should take a look at municipal bonds. they're not taxable at the federal level (though provide lower returns as a result).

once again, please see disclaimer above about investment advice.

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