Key Takeaways
- Inflation can erode your retirement savings over time
- Traditional “risk-free” investments may not be the best hedge against inflation
- Asset allocation plays a crucial role in combating inflation
- Stock market crashes can be weathered with a diversified portfolio
- Rebalancing your portfolio can help you buy low and sell high
Introduction: Navigating the Best Hedge Against Inflation in Retirement Planning
In a world where financial stability is increasingly elusive, finding the best hedge against inflation is a top priority for anyone serious about retirement planning. Whether you’re sipping on a 6-pack of beer or contemplating the complexities of asset allocation, the question remains: how can you ensure that your retirement savings last and grow?
From the so-called “risk-free” investments like Treasury Bills to the volatile yet potentially rewarding stock market, the landscape is fraught with options and pitfalls. This article aims to dissect the intricacies of these investment avenues, focusing on their efficacy as a hedge against inflation over the long term.
We’ll take you on a journey from the grunge-filled year of 1991 to the technological advancements of 2021, examining how different investment strategies have fared in the face of market crashes and inflation. By the end, you’ll have a clearer understanding of what truly serves as the best hedge against inflation in the context of retirement planning.
Let’s start with my ideal yearly spending goal: one 6-pack of beer. Yes, just one. Homer would be proud of the focus but not the quantity. We could extend this to many items or an entire budget, and the goal is the same: we need to come up with a retirement plan with enough money to cover the cost over the length of the plan.
“Risk-Free” Retirement?
The year is 1991, the release year for Smells Like Teen Spirit, Nirvana’s big grunge hit and Homer had only been on television two short years (not counting The Tracey Ullman Show shorts). Let us assume I was 60 and had just retired from a long career at Mr. Burns’ nuclear power plant.
The average cost of my yearly 6-pack is $5.58, but I’ve saved up quite a lot in my 401K: $100.00. Earning the 1991 average 10-year Treasury Bill rate of 7.86%, my nest egg will yield me 41% more ($7.86) than my spending for the year ($5.58) without touching my principal!
With all my savings invested in “risk-free” Treasury Bills and my only bill covered, life is good.
Now let’s fast forward twenty years to 2011, the year Prince William married Catherine Middleton at Westminster Abbey and the last year of NASA’s Space Shuttle program.
I’m only 80, so I still have quite a few years to go. Sadly, the Treasury rate has dropped to 2.35%, and my 6-pack is costing me $8.21 with inflation. Even worse, the 6-pack has been costing me consistently more than my yearly earnings since 2001. D’oh! This has caused my principal to drop all the way down to $71.42. Those Treasury Bills have not exactly been the hedge against inflation I had hoped.
Fast forward to the present day, 2021. I’m 90 and entering the year with $0.08 in my account. No beer for me this year! What happened to my buffer of 41%? What happened to the “risk-free” portfolio?!?!?
Treasury rates went down, but inflation continued its relentless, inevitable march.… The only consolation is that the results would have been even worse if I’d kept the funds in a bank savings account.
Now, instead of going “risk-free,” what if I had invested the same amount in a plain vanilla S&P 500 mutual fund? Some of you know three of the worst crashes in US history happened between 1991 and 2021. These included The Dotcom Bubble Burst (early 2000s), the Global Financial Crisis (2008–2009), and the Corona Crash (2020). Okay, I made up the name of the last crash, but maybe it will gain some traction.
Timeline of last three major stock markets
The Impact of Market Crashes
Remember Pets.com, Toys.com, and WebVan.com? These were all significant stock plays in the late 1990s. The media focus, day-trading (a term invented during this period), and excitement around these stocks were as big as GameStop and AMC were in 2021 and AI stocks are becoming in 2023.
When these and other internet stocks cratered, the Dotcom bubble burst, resulting in the longest bear market of the 30 years reviewed. There were three consecutive years of negative S&P returns in 2000, 2001, and 2002: -9.10%, -11.89%, and -22.10%, respectively. That’s a hard run. It was 43 months from peak to bottom, and the decline totaled 34.0%. It took 47 months before the market fully recovered.
Then came the Great Recession from 2007 to 2009, triggered by the subprime mortgage crisis. It “only” took 16 months to reach the market bottom, but the trough was deeper, with a decline from the peak of 49.3%. However, it took 47 months, like the Dotcom Bubble, before the market fully recovered.
Finally, fresh in everyone’s mind is the recent CoronaCrash (the name is growing on you, right?) this past year. As the world entered lockdown to prevent the spread of the virus, the decline was fast, going from peak to trough in less than two months. The S&P was down more than 37% at the trough, but the bounce back was just as quick as the market regained its lost ground in only five months.
Gosh, with all those crashes, investing in the market sounds like a terrible investment to protect from inflation.
Stock Market Returns
Since we at Purpose Built believe in and live index investing, let’s see how my original investment would have looked if I had invested the entire $100 balance in equities, specifically the S&P 500 index.
Here are the returns for the three years highlighted earlier.
- 1991 – Retirement: The return was 30.5% or $30.47 earned—plenty to cover my $5.58 in expenses. The ending balance was $124.89.
- 2011 – 80 years old: The return was 2.1% on a balance of $337.95 or $7.13 earned compared to my expense of $8.21. Negative, but the higher balance allowed me to spend some of the principal without worrying. The crash years were much worse than that. Ending balance was $336.88.
- 2021 – 90 years old: Entering the year with a principal balance of $1,066.07! It will take a record decline pretty darn soon for me not to be able to afford my beer. (Please, someone knock on wood.)
As you read in the Crash section, it has certainly not been a smooth ride. It’s easy to gloss over this, but I want to highlight one again —the 2009-2001 crash.
To get these excellent results, you would have had to keep your portfolio 100% invested during THREE CONSECUTIVE years of declining portfolio balances, ending with a year that was 22% down! But the end results are striking if you could have held your positions. Entering 2021 with a portfolio 1,066% more than your starting portfolio is hardly immaterial.
With an expected expense in 2021 of $9.58, I would much prefer to have $1,066.07 in the bank instead of $0.08. Now, that is a proper hedge against inflation!
Conclusion
GO 100% EQUITY!!!?
No, that is too simplistic. There are reasons we do not go 100% equity. If you panic during one of these large stock market crashes and the anxiety causes you to liquidate a portion of your portfolio, it can put you years behind your original plan. Selling low and then buying high is a plan killer. Think back to the Dotcom Crash. Somewhere during the third year that finished 22% down, would you have called up your advisor and had him sell everything or just fired him outright? Nosce te ipsum.
Having a portion of your portfolio in bonds that increase when the market is crashing both lessens the downside and makes you feel better about the position of your portfolio, which is a temporary dumpster fire. Holding different asset classes also provides the opportunity for rebalancing. Rebalancing sells the assets while they are at high valuations and purchases other assets while they are low—the very definition of buying low and selling high.
Lastly, if you are still panicking, it may help if you listen to this calming guided meditation from renowned index investor JL Collins.
What if you need clarification on your risk tolerance? Purpose Built can help you run different scenarios for the impact on your portfolio of different allocations, but it is essential to realize that continually increasing your bond allocation does not always make your portfolio safer; it trades one risk for another and is certainly not the ideal hedge against inflation.
If you have any questions about protecting your retirement savings from inflation or any component of your financial plan, such as deferred compensation, don’t hesitate to reach out to Purpose Built. We’re here to help you navigate your options and maximize your financial opportunities. Act now and secure your financial future today!
Disclaimer: The information provided in this blog post is for informational purposes only and should not be considered financial advice. Consult with a financial advisor for personalized advice tailored to your individual needs and verify any information with your HR representative, as plan guidelines are constantly changing.
Frequently Asked Questions
Is inflation really that big of a deal for retirement planning?
Yes, inflation can significantly erode your purchasing power over time, making it a critical factor to consider in retirement planning.
What are some good hedges against inflation?
Equity and your own personal income generation remain the best hedges against inflation but diversifying your portfolio with assets like real estate, commodities, and TIPS can offer some protection against inflation.
How often should I rebalance my portfolio?
The frequency of rebalancing depends on various factors like your risk tolerance, investment goals, and market conditions. It’s advisable to consult a financial advisor for personalized guidance but I will leave you with this fantastic white paper on rebalancing by Vanguard.
Can I rely solely on “risk-free” investments for retirement?
While “risk-free” investments like Treasury Bills are less volatile, they may not offer sufficient protection against inflation. Diversification is key.
What role does asset allocation play in combating inflation?
Asset allocation helps you diversify your investments across different asset classes, potentially offering a better hedge against inflation.
Note: There is no one-size-fits-all approach to retirement planning. Consult a financial advisor for personalized advice.
.jpg)
