How Retirees Can Outpace Inflation

Sam-deleo

By Sam Deleo
Tucker Advisors Senior Content Specialist/Editor

As October drew to a close, our national rate of inflation rose to a whopping 5.4%. The Federal Reserve also announced they would not raise interest rates, but would gradually begin decreasing the bond-buying program they had enacted in order keep credit rates low. While the market remains strong, how does this news affect the savings of retirees or those about to retire? 

One major consequence is that many retirees, who in the past have relied on bonds as secure instruments, may need to rethink this strategy. As Brett Arends wrote in MarketWatch on October 26th, “Last week the U.S. bond market’s prediction of U.S. inflation for the next five years leapt to 2.91% a year—the highest figure this millennium. That tops the inflation fears that surged in 2008, just before the financial crisis, and a previous peak in early 2005, when the housing market was out of control.” 

Many retirees remember the double-digit inflation of the 1970s, along with fuel rationing and long lines at the gas pumps. Arends points out how today’s inflation is much lower, but also much different in context. 

“Back in the 1960s and 1970s, bonds paid high rates of interest. So even though consumer prices were rising by 4% or 5% or 6% for most of the decade, the interest rate on bonds was still higher. So you had a cushion,” Arends writes. “In 1973, when inflation surged to 6.2%, 10-year U.S. Treasury bonds were paying 6.6% and BAA investment grade corporate bonds about 8%… In 1978, when inflation hit 7.6%, Treasuries were paying north of 8% and BAA corporates north of 9%. Bondholders still (eventually) got hurt: Soaring inflation caused bond prices to tumble. And at the peaks, in 1974-75 and 1979-80, the inflation rate overtook their interest rates. But overall the bonds helped compensate them for higher prices. Not today.” 

As of October 26th, the interest on a 10-year government bond was posting around 1.62%, while 30-year bonds hovered around 2%. So, bondholders stand to lose money even if interest and inflation rates don’t rise, and they stand to lose substantially if the latter continues to rise or remain at a high level. Additionally, CD and money market rates are well below 1%, and the average interest for a savings account in the U.S. now tops out around .06%. 

A story in the New York Times last week pointed out that the bond market’s expectations for inflation over the next five years had reached a new high of just over 3%. But whether 2.91%, as Arends wrote, or just over 3%, it’s not great news, and it contradicts the messaging that has been coming from the Federal Reserve about plus-2% inflation lasting only a year or two at most.   

So, how do people who are retired or about to retire combat this inflation? How can they ensure that their savings don’t lose money? Let’s look at a few of the more common options people choose for their portfolios. 

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1. All Equities

Equities should be a part of any portfolio, and some people go so far as fill their portfolios exclusively with equities. In a largely bull market like the one we’ve seen over the last 18 months or so, an all-equities strategy would have greatly exceeded the rate of inflation. For people 10 or more years away from their retirement, this strategy could work very well, provided they have the time and expertise to study stock options every day and/or can rely on a financial advisor to help them with their choices. In the worst-case scenario of a market crash, these individuals would still have time for the years a portfolio recovery would necessitate. But for someone retired or nearing retirement, this strategy could be fatal to their portfolio. 

Market crashes can take five years or more for people’s financial portfolios to be made whole again. If people looking to retire or already retired are relying exclusively on equities for income, a crash, or even a steep correction, could effectively either end or greatly delay their retirements. In all likelihood, they would need to continue working for many more years or reenter the work force they left. An all-equities approach is much too aggressive to safely fund a retirement, and it carries risks that could be devastating to a retiree’s portfolio.

2. Stocks and Bonds Blend

A stocks and bonds mix is one of the most common strategies people choose for their financial portfolios, and many of us have traditionally believed in it as an approach that strikes a healthy balance between risk and security. But maybe we haven’t been accurate in that belief. 

Economist Roger Ibbotson and his team at Zebra Capital Management ran hypothetical return simulations from the years 1927 to 2016, which included both rising and falling yields. Their research showed that, net of fees, fixed indexed annuities had an annualized return of 5.81%, compared to 5.32% for long-term government bonds. The return for large-cap stocks over that period was 9.92%, again proving that an all-equities portfolio is a strong choice for those not yet retired or preparing to enter retirement. 

Ibbotson’s study also showed that during below-median bond return periods from 1927 to 2016, a 60/40 stocks and bonds portfolio returned 7.6%, on average. For a 60/20/20 stocks, bonds, and fixed indexed annuities portfolio, the return for that same time was 8.12%. And, a 60/40 stocks and fixed indexed annuities portfolio produced 8.63%. Individually during the below-median periods, fixed indexed annuities (FIAs) produced a 4.42% return, while bonds returned only 1.87%.  

In above-median bond return periods, FIAs reduced returns, with long-term government bonds returning 9% and FIAs only 7.55%. Ibbotson explained that, in falling yield environments, a large portion of the bond return is capital gains, enabling them to outperform FIAs. 

“I’m not necessarily advocating you go all in,” Ibbotson said about FIAs in the paper. “I think combinations of stocks and bonds and fixed indexed annuities are good.”

3. All Annuities

But what if someone did go “all in” on fixed indexed annuities in a portfolio, as Ibbotson mentioned. How would that play out against inflation? Not very well, actually. 

Even strategically chosen annuities—and let’s be clear, annuities should not be purchased any other way—will likely not be able to hedge against a sustained inflation rate of say, 5% or thereabouts. An annuity that pays someone $800 per month in 2025 will still only be paying $800 a month in 2035 or later. Also, the interest offered by annuities does not compound in the same way as the rate of inflation. If the participation rate of an annuity is 87%, for instance, and the interest is at 4%, it is easy to conclude that the purchasing power of this money would actually decrease in years of high inflation, much in the same way annuities cannot capture all of the gains in a high-growth market. 

There are inflation-adjusted annuities, known as Treasury Inflation-Protected Securities (TIPS), but the rate of return reported on Oct. 21, 2021, for a five-year TIPS was -1.685%, a record low. This means a policy holder is earning 1.685% below the inflation rate, or, according to TIPSwatch.com, investors are paying about $109.51 for $100.14 of value.

4. Annuities and Stocks

The stock market is not going to outpace inflation every single year. But as an average, it has definitely beat inflation throughout the history of the market. 

As Ibbotson pointed out, during a below-median bond market period like the one we find ourselves in, a 60/40 stocks and fixed indexed annuities portfolio produced an 8.63% return over the near 90-year period of his study. In this blend, the annuity portion of the portfolio is not expected to compete with inflation, because it can’t, and that’s not what it is designed to do, anyways. The equities take care of that, as an average over time, while the annuities anchor future income for retirement. 

Those retirees who still feel inclined to add stocks to their portfolio can do so, but they should read Ibbotson’s study first. His research shows that there is no historical market evidence to choose bonds over annuities for the “safe money” portion of one’s portfolio—especially in high-inflation environments like the present.  

“Because of issues like inflation, longevity, and income insecurity, to name just a few, the first step for any person preparing for retirement is to meet with a financial planner who specializes in retirement planning,” said Tucker Financial President Darren Petty. “This way, people can better identify the assets they need to take risks with in order to outpace inflation. Many folks are being forced out of low-risk investments now, and it’s been happening for a long time, actually. So, people move from fixed income, like bonds, into equities. Make your income-producing assets produce income and let your growth assets grow. That’s the foundation of any retirement plan: Identify the portion of your portfolio that needs to pay you in retirement, and therefore, isn’t exposed to catastrophic losses. And then, place the remainder of the portfolio in equities.”

“Especially given the fear of inflation, it’s easy for us to fall into the myth that all of our income always has to be increasing,” said Petty. “But that is usually not the best way to secure income for the future. Also, it ignores the fact that some annuities are paying 5.5% to 6% in interest.”

The No. 1 way for retirees to worry less about inflation is to get their asset allocation right. A balanced retirement portfolio should have growth assets and income-producing assets.

How those asset allotments figure into a sound retirement plan is different for everyone. But, with the help of a retirement planner, it’s the key to a portfolio unlocking the threat of high inflation.

Notes

For more information about retirement strategies to outpace inflation, email Jason.Demers@TuckerAdvisors.com or Kyle.Savner@TuckerAdvisors.com. 

Sources: 

  1. MarketWatch 
  2. The New York Times 
  3. Fixed Indexed Annuities: Consider the Alternative,” Ibbotson
  4. TIPSwatch.com 

– For Financial Professional Use Only. Insurance-only agents are not licensed to offer investment advice.

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