Print
A question I have been considering, and which recent events have made more urgent, is what retired investors (or those close to retirement) should be thinking as they look at the inflation figures. Is there something they should be doing? If so, what?
Inflation in Context
As always, let’s set the context first. In the past year, inflation has ticked up sharply and is now at a 40-year high. Put that way, it sounds terrible. On the other hand, inflation was down sharply the year before that. If you look at inflation over the past two years, it is a bit high, but it is still within the range we have seen in the past decade. If we expect inflation to drop over the next couple of years, neither panic nor significant changes would be needed.
Until very recently, that seemed to be the most likely outcome. Surveys indicate expected inflation over the next five years should be around 3 percent. Looking at what the fixed income market was telling us gave the same story. There were good reasons to believe that inflation would drop through the rest of the year, on its way back down to around 3 percent or so over the next five years. That would have been about where we were over the past decade. Not great, but not terrible either.
The Effects of War
Now things have changed. The war in Ukraine has had terrible consequences already, but one of the biggest pending financial consequences is likely to be higher inflation, which will affect everyone around the world. Two of the major components of headline inflation, food and energy, are both directly affected by the war—and that will keep inflation higher for longer, likely for at least the next several years.
For food, both Ukraine and Russia are among the largest exporters of wheat and grains in the world, and both will be offline for the foreseeable future. Grains are a major input to most food prices, and the shortages will drive food prices higher. For oil and gas, Russia is again one of the largest suppliers in the world, and the same effects are already hitting markets and driving prices higher.
Beyond the level of inflation, what makes this expected impact especially damaging is the fact that the usual remedy of tighter monetary policy won’t work. Higher interest rates won’t grow more food or pump more oil. So, the damage is likely to be worse, and last longer, than it would if the inflation came from other components. It is also likely to be largely unavoidable, as people have to both eat and heat their homes. Food and energy are not optional expenses.
What Should Retirees Focus On?
If this is a pending problem, what should we do if we are in, or close to, retirement? For most retirees, a primary focus is on income, and here there are two things to look at.
Duration. For fixed income, or bonds, the key thing to look at is duration. In financial markets, this is usually expressed as how much the price of a bond changes as interest rates shift. For our purposes here, I want to think of it as how long until we can reinvest the money at a higher rate. If rates are going up, the sooner we can reinvest that capital and take advantage of that higher rate, the better. Retirees in a rising-rate environment should consider keeping the duration of their bonds relatively short. Yes, that means they may get less income in the short term, but it also means they are not locked into that payout and have the opportunity to roll over into a higher-paying bond as rates rise.
Equity. The second thing to look at, beyond bonds, is equity for income. If you look at a dividend-paying stock, for example, you can get as much as or even more income than from a bond. Yes, there is more capital risk potentially—the stock may drop more than that bond. But for many stocks, there is much less income risk than capital risk. Companies really don’t like cutting dividends. Over time, in fact, those dividends are likely to increase, if you pick the right stocks, even as the value of the stock is likely to recover. For more capital value uncertainty in the short term, you could get a rising income stream and the probability the capital value will recover and even rise. It is a tradeoff, but for investors in an inflationary environment, it could help them meet their goals.
Understand the Risks
As always, of course, there are risks with any strategy like this. Investors should talk with their advisors to understand the risks and the tradeoffs—but also consider the advantages. Do investors have to make changes? Probably not. Should they make changes, or do they want to make changes? Very possibly. Focusing on income over time is potentially a good way to do just that.
Bonds are subject to availability and market conditions; some have call features that may affect income. Bond prices and yields are inversely related: when the price goes up, the yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity.
