As you save up for retirement, you need to keep inflation in mind. It may seem like you are fighting a losing battle against inflation. After all, it reduces your rate of return on investments over time. But the battle is far from already lost. As long as you recognize that inflation is an issue, you can take steps to mitigate inflation risk.
A Quick Refresher on Inflation and Your Investments
As a refresher, remember that inflation refers to when goods and services are worth more. In terms of investments, inflation will offset your gains, hurting your return rate. For example, assume your portfolio has a 5% return rate, but inflation is 2% for a given year. Once you adjust for inflation, your net return is just 3%.
Historic Inflation and Current Inflation
You can get an idea of the extent of inflation risk to your portfolio from historical figures. The worst inflation in recent history was during the late 1970s and early 1980s when it was over 13%. However, that is very high, and during the early and middle of the 1990s, it was just 3 to 5%.
The good news is that recent figures are the most important for your retirement portfolio. Past inflation already affected where your retirement savings are currently at. This is especially good news given that since 2000, inflation has remained at about 2% per year.
The bad news is that inflation is now over 5% year-over-year. If inflation remains near this level for the next few years, it will have a serious impact on many people’s lives.
But Retirees Lose the Most From Inflation
While inflation has been lower in recent years than several decades ago, you still need to think about it. After all, once you retire, you are on a fixed income, and you won’t get raises or bonuses to adjust for inflation.
You will have the same income every month, but every year, your purchasing power will decrease slightly.
This means you have to plan accordingly and choose wise investments, focusing on those least affected by inflation.
Know Which Investments Are Most Affected by Inflation
While you want a diversified retirement portfolio, you can minimize the inflation risk by focusing on investments that are less impacted by inflation.
The following are not those investments, and these are the types of investments that are most negatively affected by inflation. Just remember that that doesn’t mean you need to ignore these investment types. They still have a purpose but should be minimized.
The lack of ability of savings accounts to overcome inflation comes down to simple numbers. If you have a savings account that earns you 1% interest per year, but inflation is 2%, you aren’t keeping up with inflation.
When you hold a bond until maturity, you receive a yield. That yield consists of the bond’s nominal interest rate minus inflation. So, a 3.5% bond and 2.5% inflation would give you 1%. If inflation is greater than the yield on your bond, you haven’t gained anything. In fact, you are losing money.
Remember that even a bond ladder, where you buy bonds so that one matures each year, will be affected by inflation.
Assuming your pension doesn’t have a cost-of-living adjustment, which it likely doesn’t, it has a high inflation risk. There is simply no mechanism built in to compensate for inflation.
Calculating The Impact
A financial advisor can help you figure out the impact higher inflation will have on your investments and your retirement plan. You can also run your own inflation-based scenarios in retirement planning software such as The WealthTrace Retirement Planner and Personal Capital.
The Best Investments to Reduce Inflation Risk
Now that you know which investments make you the most susceptible to inflation, which ones have the lowest inflation risk? The following are the best investments to make if you want to protect your retirement portfolio against inflation.
It technically isn’t an investment, but social security is an important part of your retirement income. Luckily, it includes a cost-of-living increase. Every year, it has a cost-of-living increase based on inflation and other factors.
You can also get creative with social security and defer your benefits to give yourself a slight raise in later years. The idea here is that the increase in benefits will help offset inflation later on.
Mutual Funds and Stocks
Historically, stocks are the best way to fight inflation, and they have the highest returns. Just make sure not to invest too much of your retirement portfolio in stocks as you get closer to retirement due to the risk of losses. At the same time, you don’t want to be too conservative, as stocks are among the best choices for overcoming inflation.
Investing in stocks is especially helpful for fighting inflation if you opt for dividend-paying companies.
TIPS (Treasury Inflation-Protected Securities)
As the name implies, these are a type of U.S. Treasury security that protects against inflation. TIPS will increase with inflation. They are also backed by the Treasury, eliminating any default risk.
Yet another option is to invest in real estate for rental income. This is a popular option, especially with low-interest rates. That is because rental income tends to deliver higher yields than bond yields or dividend income. Investment properties can net you 6 to 8% annually, and it will also typically increase with inflation.
The Bottom Line
While you want to keep your portfolio diversified, the best retirement portfolio will focus on investments with the lowest risk of being affected by inflation. These include stocks, mutual funds, TIPS, and rental income.