Inflation is a major risk for everyone, and retirees are especially vulnerable. If you don't manage this risk properly, you'll rely on Federal policy to offset the damaging impact of surging prices for consumer goods. Fortunately, there are a few strategies that I embrace for more control over my financial circumstances. These steps give me a clearer picture of my retirement plan and directly offset the impact of inflation.
Investing my savings for growth
Inflation reduces the buying power of the dollar. As the money supply grows, it influences supply and demand forces throughout the economy and results in higher prices for all sorts of goods, services, and labor. If you hold your savings in cash, then the actual value of that cash tends to decline over time -- especially during periods of high inflation.
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Fortunately, there's a clear and well-established strategy for asset preservation. Like goods and services, the dollar-denominated price of equity holdings tends to rise with inflation. Over time, businesses often raise prices in response to higher operating costs. This causes sales, profits, cash flows, and dividends to increase, all other factors being equal. The value of a stock reflects a company's expected future cash flows, so rising prices in the economy tend to push stocks higher, too.
This acts as an effective natural hedge against inflation. The buying power of the dollar might decline, but the dollar-denominated value of my assets should increase proportionately over time.
The stock market has outpaced popular inflation metrics, such as the Consumer Price Index (CPI), over the long term. Equities not only create a natural hedge against inflation, but they also provide growth opportunities to increase your real wealth. Social Security is a cornerstone of many retirement plans, and the cost-of-living adjustments provided by that program are an important tool for risk management.
Using inflation-protected bonds
Unfortunately, equity investments have their drawbacks. Not everyone can responsibly tolerate the volatility that's inherent in the stock market. Stocks tend to march higher with the economy over the long term, but investor sentiment can lead to steep losses in the short term. That's not great for retirees who may need to sell their assets to meet short-term cash needs. People generally increase their bond holdings over time to manage volatility risk.
Inflation risk is one of the most prominent downsides for bonds. Most bonds provide pre-determined cash flows on a scheduled basis, so the dollar value of those returns is locked in. Bond yields reflect inflation expectations in capital markets, but higher-than-expected inflation reduces the real value of future cash flows to bondholders. The Federal government combats that risk with Treasury Inflation-Protected Securities (TIPS). These debt instruments pay slightly lower interest rates than normal Treasuries, but the payouts increase with CPI. If there's a period of high inflation, these securities offset some of the bond's lost value.
TIPS aren't a perfect vehicle, but they can be a helpful tool to address inflation risk for people who need limited equity exposure. I don't have much bond exposure in my portfolio due to my current time horizon and risk tolerance, but I will include TIPS in my bond portfolio when the time comes to address volatility.
Tracking my personal data
CPI is a helpful tool for macroeconomic analysis, but it's a flawed metric for several reasons. The most prominent shortcoming is an unavoidable one. Everyone's consumption pattern is unique, so the weighted average methodology used to compute CPI isn't necessarily representative of many people's reality. Groceries tend to have a much larger impact on lower-income households, whereas luxury apparel and durable goods play a larger role for people with more discretionary spending. Education costs fall disproportionately on people paying tuition or student loans. Older people often incur higher out-of-pocket healthcare costs.
It's a good idea to analyze your spending with a budgeting program or spending tracker software. There are several useful tools provided by banks and other vendors that will compile your spending data and provide insightful reports so that you can see where your cash flow is going. This means you don't have to depend on CPI and federal cost of living adjustments -- you can focus on a more useful, personalized inflation measurement.
If my personal inflation rate exceeds the official headline figure, I need adjustments to cover the gap. Those adjustments could include a restructured budget, tax mitigation strategies, or a revised investment strategy. Conversely, my personal inflation rate might be lower than the CPI, giving more flexibility to my plan if I'm fortunate.
