Inflation Part 3: Protecting Yourself Against Inflation

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InflationOfficially, inflation today is calculated about 4%. Unofficially, it is over 7%. Since 1997 the government has stolen productivity gains from Social Security recipients and pushed middle-class taxpayers into alternative minimum tax rates. But you can learn how to hedge your assets against underreported inflation and protect your retirement goals.

First, don’t count on Social Security for your retirement, especially if you are young. It may be unthinkable, but Social Security payments will probably be eliminated for the middle class and above. And even if you qualify, the government’s official cost-of-living adjustments will continue to be calculated significantly below actual inflation. If you don’t keep pace with inflation, by the end of your retirement you will have lost your lifestyle, your independence and ultimately your dignity.

An irresponsible government may underreport inflation and jeopardize the retirement of truly needy seniors. But responsible citizens will strive to take care of themselves in retirement without government assistance. Public funds thus will be available for those who can’t take care of themselves. In other words, financial planning is simply planning not to be the truly needy.

Second, ask yourself, “What are safe investments that should more than keep up with inflation?” This is a challenging question.

Because of inflation, cash, normally a safe store of value, has been the riskiest investment since 2002 when the U.S. dollar began losing much of its purchasing power. Since then, the U.S. Dollar Index has dropped over 39%, from 120 to 72.95. It has also dropped more than 44% against the euro and over 67% against gold.

During inflationary times, U.S. bonds are not a safe store of value either. They pay a fixed rate of return in diminishing dollars. In a rising interest rate environment, intermediate- and long-term bonds drop in value too. When interest rates are rising, keep your money in a money market account where the rates adjust immediately.

Inflation-indexed bonds only do slightly better. Because actual inflation is underreported, these bonds have not kept up with the real inflation rate. The adjustments on them are tied to the official consumer price index, so they also are depreciated for any productivity adjustments. These investments may do better but only to the extent that inflation is reported accurately.

Foreign bonds provide the best protection against a falling dollar but only if they are unhedged. Many foreign bond funds hedge their investments against a rising dollar, providing returns tied to U.S. dollars. If your goal is to guard against a falling dollar, a fund that hedges against the dollar defeats this purpose.

Unhedged foreign bonds yielded about a 10.5% return in 2007 and about a 6% return so far in 2008. Determining if a foreign bond fund is unhedged can require some research. Also, foreign bonds of developed countries perform differently than those of emerging market countries. They represent two distinct baskets of currency. Emerging market bonds at times have a higher return, but they also have a higher risk and volatility. We recommend putting a small portion of your foreign bond allocation into emerging market bonds.

The danger with any unhedged foreign bonds is that the U.S. dollar may strengthen against foreign currencies. Also, unhedged foreign bonds cannot protect you against global currency inflation. So you don’t want all of your fixed-income investments in unhedged foreign bonds, although this investment does protect you to some degree against U.S. dollar inflation.

Cash, U.S. bonds and foreign bonds are all investments for stability rather than appreciation. Stable fixed-income investments generally make about 3% over inflation. It’s not a wide enough margin to stay ahead of inflation during times when interest rates are low or rising.

A significant allocation to appreciating equity investments is necessary to accomplish the long-term growth that ensures a comfortable retirement. Equity investments, on average, make about 6.5% over inflation. Although they are more volatile in the short term, they give you a better chance of achieving the appreciation necessary in today’s longer retirements.

The third way to protect your portfolio against inflation is to refrain from being too aggressive or too conservative. Keep most of your investments in appreciating equities, but plan the next five to seven years of spending in stable fixed-income investments.

If you don’t have the next five years of spending in stable investments, you may be forced to withdraw from your portfolio while stocks are down. Your portfolio will be depleted and unable to rebound. However, if you are too conservative, you may sleep well tonight but eat poorly a decade from now because your fixed-income investments haven’t exceeded inflation.

The balance between risk and return should not depend solely on your emotional risk tolerance. Rather you should focus on what risk-return allocation mix affords the best chance of meeting your investment goals. Your allocation to stability should be fixed and your allocation to appreciation should appreciate. The goal of stability eliminates risky, or junk, bonds. The goal of appreciation also eliminates speculation, which adds needless noise rather than real return.

The fourth principle is that investing for appreciation means selecting only investments that on average go up, are publicly traded, and have low expenses and fees. Savvy investors buy shares of long-term businesses that produce worthwhile goods and services.

Speculation, in contrast, can include trading options or commodities. It can encompass limited partnerships or hedge funds that are illiquid and often subject to high fees and expenses. Diversification does not mean buying every kind of investment regardless of its suitability to help you meet your financial goals.

The fifth protection against inflation is to guard over half of your portfolio against the risk of a falling dollar. The asset classes of foreign bonds, foreign stocks and hard asset stocks offer the best protection. As a class, hard asset stocks have also yielded one of the best returns since 2002.

Hard asset investments include companies that own and produce an underlying natural resource, such as oil, natural gas, precious metals, base metals, and other resources such as diamonds, coal, lumber and water.

Keep in mind that investing in hard asset stocks is not the same as investing directly in commodities. Buying gold bullion or a gold futures contract is an investment in raw commodities or their volatility. Buying a gold mining company is a hard asset stock investment.

The Goldman Sachs Natural Resources Index tracks hard assets investments. It is comprised of 85% energy and 13% materials. At the end of May 2008, this index was up 12.12% year-to-date. Its three-year annualized return is 30.47%. Its five-year annualized return is 29.56%.

Foreign stocks also protect you against a falling dollar. They are priced in foreign currencies and benefit when the dollar drops in value.

The MSCI EAFE foreign index is only down 3.03% year-to-date compared with the S&P 500, which is down 3.80%. Over the past five years of a dropping U.S. dollar, the MSCI EAFE index has on average done much better than the S&P 500.

Adding international investments to your portfolio is an excellent way to diversify for safety while boosting returns. International stocks have appreciated more than U.S. stocks. What’s more, companies located in countries with the most economic freedom have appreciated more than the broader international average.

Since 1994, the Heritage Foundation Index of Economic Freedom has used an empirical system to measure economic freedom in countries worldwide.

One of the 10 categories it measures is monetary freedom. The worldwide average inflation rate per country from 2004 to 2006 was 10.6%. Having a monetary authority to maintain a sound currency clearly is critical to economic freedom. As the Heritage Foundation report states, “Monetary freedom is to market economics what free speech is to democracy. Free people need a steady and reliable currency as a medium of exchange and store of value. Without monetary freedom, it is difficult to create long-term value.”

When investing overseas, emphasizing countries with the most economic freedom can help prevent trying to avoid U.S. inflation only to be caught in some other country’s inflation.

Finally, tax management is critical. Underreported inflation pushes middle-income Americans into higher tax brackets. Many techniques to tax-manage your investments are worth exploring. Putting fixed-income investments into pretax accounts and foreign stocks into taxable accounts can mean a tax benefit of about 1% a year.

Normally a Roth conversion does not have any benefit unless you are in a higher tax bracket during retirement. With inflation underreported, you are being pushed into a higher tax bracket every year. And with the political winds portending higher taxes regardless of inflation, you will almost definitely be paying more in the future. Paying the taxes now and funding or converting to a Roth account while you have a relatively low rate could result in significant tax savings.

So despite inflation rates that are higher than reported, you can still protect your investments, achieve your financial goals and enjoy a comfortable retirement.

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President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.