The Troubles Of Hedging Inflation In RetirementGuest Post
There’s no free lunch. The ideal of an inflation-protected defined benefit plan was indeed wonderful, but the costs were prohibitive. Few companies were willing to shoulder the costs of them, and what few were willing ran into the roadblock of the IRS telling them they could not put too much into their defined benefit plans — for the IRS feared it was a tax dodge.
By nature the IRS is shortsighted, and could not appreciate the idea that you needed more assets than the liberal (meaning you don’t need to contribute much today) funding formulas said they would need. The IRS wants taxes now. They don’t care about taxes five years from now, much less thirty.
As it is today, most of us (including me), are stuck in the box where we have to make our assets last over our retirements. There are no guarantees. How do we make the assets stretch?
It’s a tough problem. I often talk to my friends about the challenge, because we really don’t know whether the idiotic policies of our government will lead to inflation or deflation as a result of the crisis. Most people assume the government will inflate, and that seems to be an easy solution.
But they didn’t do that to any great extent in the Great Depression or in the 2008-9 financial panic. I’ve got bad news for most people: the government of the US, nay, most governments tend to favor the rich. As such, they tend not to inflate aggressively.
But as with most matters in economics, past is not prologue. Who can tell what the government might do in an entitlements crisis mixed with a weak dollar? What happens when so much credit is extended that foreign creditors distrust the value of the dollar (or euro)?
But suppose inflation is your worry. How can you hedge?
First there is storage: t-bills and gold. You won’t earn anything, but you won’t lose anything either.
Wait, why not buy gold miners? I class gold miners in the basket of industries that I call “cult industries.” Cult industries attract businessmen and investors that are “true believers,” who have a view of the world that says the activity is more valuable or cool than most other industries.
The problem with gold miners is depletion. Has the price of gold risen? Yes, but so has the cost of mining gold. There are many people who have bitten the romantic lure to mine gold, and as such, typically gross margins are poor. Buying gold miners has been a bad bet for a long time. So just buy a little gold instead, and not the miners.
Short duration bonds can be useful if their yields are higher than expected inflation plus default losses. Otherwise, bonds are usually not a good hedge for inflation.
With stocks, for the market as a whole, rising inflation is a small net negative. Businesses will raise their prices, but a higher cost of capital overall will make stocks lose ground to inflation in real terms.
But if you tweak your stock portfolio, and pursue either a low P/E approach, or one that favors a overweight of cyclicals, you can use those stocks as a hedge against inflation. Just be aware that when the cycle shifts to deflation, those stocks will underperform.
Real estate typically does well in times of inflation, just make sure any loans you have against the real estate won’t reprice upward to reflect the new higher interest rates.
That’s my quick summary for asset classes. Before I close, I have a few words regarding the unique ways that inflation affects seniors:
First, inflation affects you more because you don’t have wage income coming in. Wages mostly adjust to inflation — if you have work, that is a source of support.
Second, things that are necessary — food, energy and healthcare, have tended to inflate at a rate faster than other goods and services. That might not be true of energy now, but it was true for a long time.
My main bit of advice is to be conservative in your spending. That’s the one thing you can control. Making assets last for a long time, is difficult, but it becomes impossible when your asset levels get too low.
With that, invest wisely. Personally, I would pursue a middle course that partially hedges inflation risk, because the cost of being wrong on either side is significant.
Article by David Merkel, The Aleph Blog