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How Inflation Really Hurts Retirees — and What to Do About It

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What You Need to Know

  • Many investors and advisors fall victim to the money illusion by focusing too much on change in assets instead of change in spending power.
  • I bonds provide higher returns than TIPS.
  • An even better deal on inflation-protected income: waiting to claim Social Security.

Inflation jumped 7% in 2021, as measured by the consumer price index for urban consumers (CPI-U). Price increases for goods ranged from stratospheric (51% for gasoline) to “meh” (1.6% for dairy products).

For the most part, inflation followed a sharp post-vaccine increase in transportation as Americans returned to work. However, other price increases, such as increases in the price of beef (18.6%) and pork (15.1%), are the result of supply chain and labor shortage issues that have plagued the global economy.

Understandably, the reemergence of inflation is upsetting to many Americans. Huge price increases in red meat, cars, and gasoline (so-called “manflation”), and far more modest price increases among many other consumer goods and services reflect the idiosyncratic nature of the 2021 rise in consumer prices. 

When inflation rates are uneven among goods and services, this creates opportunities for consumers whose budget is more flexible to hold off on buying a new car, delay a cross-country trip, or swap chicken (up 9.5%) for beef.

Retirees who don’t need to commute can likely weather today’s inflation storm more easily than workers. And many of the expenditure categories that rank high on a senior’s budget, such as medical services (2.5%) and prescription drugs (0.0%), weren’t affected at all. 

The Money Illusion

Investors flush with an unprecedented inflow of cash during the pandemic increased their investments in money market assets by 20% from $3.63 trillion to $4.33 trillion in 2020. These cautious investors saw their purchasing power drop by at least 6% in 2021. 

After decades of modest prices increases, Americans are rediscovering a source of risk that many had forgotten existed. We can lose purchasing power if our money buys less stuff.

It’s not uncommon for advisors to dismiss inflation risk as a historical artifact long ago tamed by central banks. The tendency to focus more on the change in our balance sheet instead of the change in our potential lifestyle is a phenomenon known as the money illusion.

A retiree with $1 million invested in corporate bonds on Jan. 1, 2021, had about $985,000 on Dec. 31, 2021 after a modest loss. But they could only buy $916,000 worth of goods and services. This is a much greater loss.

Imagine planning for a vacation in England in June. You’ve set aside $4,000 in a checking account to pay for 3,000 British pounds worth of hotels, fish and chips, and lukewarm beer. Between January and June the exchange rate shifts, and suddenly it takes $5,000 to pay for your vacation.

Even though you still have $4,000 in the checking account, you’ve taken on a new form of spending risk by not protecting yourself against the price change that is no different than an investment loss.

In 2019, Boston University economist Zvi Bodie and his co-author, the late Dirk Cotton, made the point that planning a retirement using nominal dollars rather than after-inflation dollars is no different than speculating on the future value of a foreign currency.

A retiree who planned to spend $50,000 in 2022 speculated earlier that $50,000 nominal dollars would be enough to pay for the lifestyle they hoped to lead. They gambled on modest inflation and got unlucky.

In a 2014 Harvard Business Review article, Nobel Prize winning MIT Professor Robert Merton compared the near-zero perceived volatility of a Treasury bill portfolio to the volatility in the amount of after-inflation income a retiree could buy from their T-bill investment.

While the asset value of T-bills is flat, the amount of after-inflation income they can buy with a stable nominal income jumps up and down over time. Merton made the point that inflation risk is no different than risk in nominal investment returns.

Many investors and advisors fall victim to the money illusion by focusing too much on change in assets instead of change in spending power.

Warnings from economists like Merton and Bodie largely fell on deaf ears, but since 2019, growth in inflation-protected Treasurys rose by more than 50% and the percentage of Treasury inflation-protected securities purchased by investment funds at auction rose from 50% in 2016 to 80%.

The iShares TIPS Bond ETF (TIP) returned 6.05% over the last year, more than 7% higher than an investment in the Bloomberg Barclays U.S Corporate Bond Index. The TIPS fund provided consumers with preservation of spending power. 

The strong demand for inflation protection has pushed TIPS yields below zero, locking investors into a negative real return on savings. Assets that historically generated a risk premium have outpaced inflation.

A recent CFA Institute blog post by Nicolas Rabener, managing director of FactorResearch, pointed out that the historical real rate of return on stocks when inflation is between 5% and 10% is positive, although it is a modest 4.8%.

Among stocks, sectors related to commodity production did much better, and according to a recent Vanguard report, commodities “stand apart as a vehicle for hedging against unexpected inflation.”

Investing in stocks and commodities does involve the acceptance of investment risk. For those who want greater certainty, the good news is that retirees can buy inflation-protected investments at below-market prices. 

Cheap Inflation Protection

A recent article by Jeffrey Levine, chief planning officer at Buckingham Wealth Partners, highlights the benefits of the oft-forgotten Series I Savings Bond, or I bond. I bonds are suddenly a hot topic since they provide higher returns than TIPS because their fixed (pre-inflation) rate is currently 0% while the yield on 5-year TIPS is currently -1.2%.

So investors get a 120 basis-point bonus over the market price of inflation-protected Treasurys, and this fixed rate never goes down. The most common fixed rate on I bonds over the last 12 years has been 0%, so you’re not really losing out by buying one today.

Any I bond purchased until April 2022 earns 7.12% for the first 6 months you own the bond and the principal value rises by the interest applied. So a $10,000 investment today will have a principal value of $10,356 in 6 months. In April, the Fed will set a new interest rate based on the CPI-U. 

Another underappreciated benefit of the I bond is the ability to defer taxation on interest until you cash it in. Compared to other taxable bonds, this can be a significant benefit as compounded growth is shielded from taxation — increasing the after-tax return for longer holding periods.

I bonds have some downsides that investors need to consider. You can only buy $10,000 per year ($20,000 for a couple), and you can add up to $5,000 from a tax refund. Although they technically have a 30-year maturity, I bonds can be cashed in after one year. If liquidated before five years, you lose the last three months of interest; wait five years, and you’re home free. 

Retirees can get an even better deal on inflation-protected income by delayed Social Security claiming. Why?

The income bonus a retiree receives from waiting a year to claim was based on mortality tables and real interest rates from the early 1980s. Higher-income retirees have made remarkable gains in longevity in recent decades, and real rates of return on inflation-protected future government payments are historically low. 

The combined benefit of improved longevity and the high cost of inflation-protected income mean that a healthy woman can receive $180,000 more in expected future lifetime income by delaying from age 62 to age 70. Many forget that retirees don’t need to take Social Security when they retire, and can build valuable inflation-protected income by using IRA savings to bridge spending before age 70.

While there is disagreement among financial experts about the permanence of recent price increases, the last year has taught us that inflation is a risk that can rear its head at any time with serious implications for retirement portfolios. 


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