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Finding Inflation Hedges in Retirement Income Planning: IA Retirement Plan Advisor for July 2010

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While inflation does not seem to be a major threat right now, some financial market gurus are nevertheless worried that it could become a reality in the not-too-distant future.

PIMCO’s CIO Mohamed El-Erian, for instance, believes that what currently looks like a period of disinflation is actually just the calm before the storm, when governments around the world, the U.S. included, will have no choice but to use their balance sheets to keep economies going, thereby resulting in inflationary pressures.

To this end, advisors such as Bethesda, Maryland-based Rita Cheng are making sure they speak about inflation with their clients. Even though the Federal Reserve appears to have inflation in check right now, investors do need to guard against it, Cheng says, because it is going to impact their lives. “As advisors, we have to make sure that peoples’ portfolios are able to create income in the future, even in an inflationary environment,” she says. “People have already been through so much with the downturn of 2008, but inflation is a concern, and like cholesterol to heart disease, it is the stealth thief of purchasing power and can compromise the quality of life in retirement if ignored.”

Cheng, who is affiliated with Ameriprise Financial Services, believes that an individual’s income needs to be compartmentalized in order to protect against inflation, and so advisors should be evaluating their clients’ income and expenses, making sure that they are diversified in their investments and keeping their risk exposure in check. “We need to make sure that we address the short erm as well as the longer term, so it’s important to emphasize having different portfolios,” Cheng says. “A client might have pension income to cover them between ages 50 and 60, for example, and then another bucket of money from age 60 onward, but they need to know this and where their money will be coming from.”

The greatest impact of inflation is that it robs purchasing power, Cheng says, and this has repercussions not only on the day-to-day lifestyle of people, but also in terms of their longer term needs, notably healthcare. “Healthcare is the biggest concern for my clients when we talk about inflation,” she says. “The pricing and the services rise at a faster rate than inflation, so this really has to be addressed very carefully.”

Cheng says that TIPs, gold, natural resources, commodities, REITs, and oil and gas all make for good hedges against inflation. “There are also many ETFs that can help advisors access asset classes to hedge against inflation in an efficient and cost effective manner.”

Experts like Mike Dueker, chief economist at Russell Investments, believe that advisors ought to really consider equities as the best possible hedge against inflation. Equities, he says, proved to be a poor hedge in previous periods of inflation, notably the 1970s, but this was because inflation then was caused by poor economic growth. If inflation were to happen again, though, equities would prove to be a great hedge because unlike in the 1970s, productivity across the globe has not slowed down to such an extent, so “equities would give people a real ownership share of the economy,” Dueker argues.

He does caution, though, that in the short term, equities are likely to underperform in the U.S., as the economy is currently in a period of low growth, “so for people banking on the stock market doing well in the first five years of their retirement, there could be some disappointment, as the recession will impact capital appreciation of equities in a portfolio.”

At any rate, Dueker does not expect to see inflation rearing its head for another decade or so. People are worried about the indebtedness of the U.S. government, he says, but in his opinion, the government’s debt load is manageable and it has no need to borrow any more at present.

Cheng, too, thinks that inflation is a longer-term concern. However, in looking to make a portfolio inflation-proof, equities are a good option, she says, in particular technology and telecom stocks, consumer staples and pharmaceuticals. “Equity exposure in areas that are growth oriented would definitely help as an inflation hedge,” she says.