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Forget TIPS; Here's a Better Inflation Hedge: Northern Trust

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What You Need to Know

  • Over time, a small rise in inflation can take a big bite out of income from a retirement portfolio.
  • Advisors should include real asset stocks within portfolios to allow them to grow with inflation, Northern Trust says.
  • Yet sectors like commodities tend to underperform when inflation is at normal levels, the asset manager finds.

With inflation hitting an annualized 7% — the biggest 12-month increase since 1982 — as announced Wednesday by the U.S. Bureau of Labor Statistics, if advisors haven’t adjusted their client portfolios already, it’s probably time they should.

Indeed, inflation can eat away at retirement portfolios even when it’s over just 2%. That’s why, according to Northern Trust Asset Management, it’s essential to add certain elements to a retirement portfolio that not only help increase performance as inflation rises, but help curb portfolio erosion.

For example, just a 1% inflation difference for an investor with 10 years to go until retirement would have a 14% decrease in retirement income. In the long term, if an investor started saving at 25 years old, and the retirement portfolio was $610,000 at age 67 in real terms, the annual retirement income would be $55,000. But at a 3% inflation rate, that balance is reduced to $401,000, and cuts retirement income to $36,000 per year.

What to Do?

“We’re definitely hearing from advisors that inflation is one of their top concerns,” said Nadia Papagiannis, practice lead, model portfolios at NTAM. “And it’s not necessarily the level of inflation, but the fact that prices are increasing and [investors] have to make sure that returns and income are increasing sufficiently to cover that.”

The key, then, is to inject specific inflation-linked investments into a portfolio — NTAM recommends an 8% allocation on the high end and 4% on the moderate to conservative end, she says.

The best products are real assets, which can pass through costs in times of inflation, which means “they are getting more revenues as prices are increasing,” she says.

These products include natural resources, real estate and infrastructure, but buying the securities — not the actual commodity — is easier for clients to understand and will provide a source of income that is higher than traditional stocks and bonds.

“For example, for natural resources, energy companies, and for real estate, landlords can pass on costs through higher rates, and for infrastructure, utilities can pass on [higher costs],” she notes.

More on this topic

In a paper, Beating Inflation in Retirement (Beyond TIPS), published in June, NTAM noted that although Treasury inflation-protected securities are “structurally indexed to inflation and will inherently move in line with inflation,” and typically are the “go-to” product advisors use in inflationary times, their “inflation beta” is less than 1.0.

However, “equity-based natural resources and commodities have statistically significant inflation betas of more than 4.0, indicating high sensitivity to inflation.”

Yet these investments have performed better when inflation is high than during “normal” inflationary periods.

Northern Trust looked at investment returns from Dec. 31, 2001 to March 31, 2021. Over that period, futures-based commodities returned 13.5% when annualized inflation was higher than 2.77%, but they declined 4.8% when inflation was below that threshold, according to the paper.

As a comparison, natural resources equities returned 20.9% in high-inflation periods versus 2.4% amid normal inflation. TIPS gained 9.2% amid high inflation, returning only 5.3% in normal inflation.

High inflation vs. normal inflation annualized returns. Source: Northern Trust Investment Solutions

From Jan. 4 through Sept. 30, 2021, natural resources equities returned 16.79%, while global real estate rose 16.02%, and global-listed infrastructure rose 4.92%. The S&P 500 rose just over 16%.

Papagiannis notes that natural resources companies are “flush with cash” and are paying it back to investors rather than putting it back into the ground. “The beauty of these investments is they can be a source of income as well as the returns keep up with inflation.”

TIPS are still a choice for conservative investors, she says, “but if you can take more risk in your portfolio, you’re going to get more bang for your buck investing in real assets for inflation mitigation, rather than with TIPS.”