When planning for retirement, retirees often forget to consider inflation. Although the longer-term average inflation rate stood at 3.13% between 1914 and 2019, the last year before the pandemic began, the current inflation rate is 5.4% — likely due to economic conditions resulting from the pandemic.
Note that even a 2% inflation rate will increase your cost of living and reduce your purchasing power by about 50% over 20 years. If that rate rises to 4%, prices will more than double in the same amount of time. Federal and state pensions usually adjust for inflation, but most private pensions do not.
For this reason, most people who face a long retirement need a strategy for dealing with inflation. People contemplating major investment decisions should contact their financial advisor. However, four investment vehicles offer inflation protection that can protect your asset values while minimizing risk.
Invest In Dividend Aristocrats
A dividend aristocrat is any company in the S&P 500 that increases its dividend at least once annually for a minimum of 25 consecutive years. The list of dividend aristocrats for 2021 stands at 65. It includes companies such as Johnson & Johnson (JNJ) and ExxonMobil (XOM).
Investors who buy these stocks should remember that no stock has to pay a dividend. The longer a dividend streak runs, the more the value of a stock depends on dividend increases. A dividend aristocrat that cuts its payout could see its value suffer for years or even decades. For this reason, these companies tend not to end annual payout increases if they can avoid doing so.
Risk-tolerant investors might choose to buy individual stocks. Investors who are more risk-averse can purchase a dividend-aristocrat exchange-traded fund such as the ProShares S&P 500 Dividend Aristocrats Index (NOBL). The payout on NOBL fluctuated over time. However, it rose from just under $1 per share in 2015 to $1.74 per share in 2020, an increase of about 74%. Over that same period, inflation produced a cumulative price increase of $14.63%, according to the Official Data Foundation, citing raw data from the Bureau of Labor Statistics Consumer Price Index.
Investor comfort levels with stocks vary. However, regardless of risk level, dividend aristocrats offer rising dividends that can produce the extra income needed to combat inflation.
Consider Real Estate Investment Trusts
REITs act as a stock portfolio with real estate holdings. These companies own or finance real estate that generates income through different types of property. Most focus on one property type such as offices, apartments or industrial sites. Others diversify into several property types, while some concentrate on mortgages only.
If a company in the U.S. becomes an REIT, it must distribute at least 90% of the net income from its properties as dividends. In exchange, all property-related income becomes exempt from federal income tax. REITs trade like a stock but allow investors to invest in real estate without the tenant and maintenance issues involved with buying and managing rental property directly.
Should inflation move higher, rising property values could increase the value of the stock in the long run. Inflation would also lead to rising rents. Thanks to the 90% payout requirement, higher rents will generally take dividend payouts higher over time. This gives investors both protection from a declining currency and a generally reliable source of cash flow.
In business terms, a commodity is defined as “any unprocessed or partially processed good.” Gold, oil, cotton, corn, orange juice and electricity are all examples of commodities. These resources serve as the building blocks of civilization, and thus hold some measure of value. By contrast, the government-backed currencies we typically use to buy these commodities tend to lose value over time.
Commodities often see wild fluctuations in value. Hence, it’s not recommended that investors speculate in these products to build wealth or hide gold bars and raw cotton in your home. Most investors should instead turn to general commodity ETFs. The largest in existence is the Invesco Optimum Yield Diversified Commodity Strategy No K-1 ETF with over $6.2 billion in assets. This and similar funds own a basket of diversified commodities. Over time, these funds should rise as the dollar loses value. Moreover, diversified funds protect investors in the event an individual commodity crashes. Best of all, with these ETFs, individual investors can benefit from rising commodity prices within the convenience of a brokerage account.
Treasury Inflation-Protected Securities
TIPS are bonds issued by the U.S. Treasury. They differ from other bonds in that the principal amount adjusts with inflation. TIPS tie the principal amount to the consumer price index. This principal amount can rise with inflation or fall with deflation. Twice a year, TIPS adjust the amount of principal according to the CPI and pay interest on the new principal value.
TIPS offer benefits besides the CPI adjustments. Because they are U.S. Treasuries, they have virtually no risk of default. Further, should deflation occur, TIPS guarantee 100% of the principal amount upon maturity of the bond.
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However, investors should remember that conventional bonds tend to figure some level of inflation risk into their rates. The interest rate on TIPS does not. Hence, in a low-inflation environment, TIPS investors may see a lower return. For this reason, consider adding conventional bonds to your portfolio in case of lower inflation.
Keep reading about inflation with 10 tips for investing in an inflationary market.
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Daria Uhlig contributed to the reporting for this article.