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How to inflation-proof your retirement

U.S. News & World Report - Money logo U.S. News & World Report - Money 9/15/2017 Rebecca Lake
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The biggest danger to your retirement security may be the one you least expect. Inflation can erode your spending power in retirement dramatically, and underestimating its potential damage can cost you.

“Inflation is often overlooked and represents one of the biggest threats to retirement, alongside an extended bear market and a sudden change in health,” says Matthew Peck, co-founder of SHP Financial in Plymouth, Massachusetts. Inflation, he says, may deliver a one-two punch if retirees are living on a fixed income and the cost of health care outpaces the consumer price index.

According to financial research organization Limra, a 2 percent inflation rate can create a shortfall of $73,376 over 20 years. The purchasing power deficit increases to more than $117,000 when inflation becomes 3 percent, and an investment strategy that isn’t designed to counterbalance rising prices only amplifies the problem.

Anthony Saglimbene, an Ameriprise Financial global market strategist based in the greater Detroit area, says obstacles often arise as investors transition from accumulating assets to drawing money from a retirement portfolio. Allocating assets too aggressively to cash and low-yield, fixed-income investments may erode your purchasing power further, leaving you even less prepared to match the pace of inflation.

Related: 10 Long-Term Investing Strategies That Work

Knowing how to adjust your investment strategy can better insulate your retirement against inflation's eroding effects.

Stick with stocks

A diversified mix of investments is critical, so if you’re worried about inflation, don't abandon stocks. Saglimbene says you can combat the long-term effects of inflation if you're investing in the right companies, including those whose profits or dividend payouts to investors increase consistently. Comparing a company’s growth rate to the overall economy is another indicator of how well a stock may be able to withstand inflation.

You should also consider which companies or sectors perform the best when inflation rises. Retailers, for example, may be hit harder, Peck says, while companies in the agricultural or financial services sectors may fare better when food prices or interest rates increase.

The predictable returns and lower volatility of fixed-income investments, such as bonds, often beckon as you draw closer to retirement. The problem is that many retirees don’t account for what the true rate of return is once inflation takes a bite, says Jack Cintorino, vice president and senior financial planner for Janney Montgomery Scott in Alexandria, Virginia.

Bonds can be particularly troublesome for investors, he says. If a bond has a nominal rate of 5 percent and inflation is 2 percent, the real rate of return is 3 percent. If interest rates are rising alongside inflation, bond prices fall, diminishing returns even more. That's why understanding the role stocks play in a retirement portfolio is so important.

“In my experience, not enough emphasis is placed on having the right percentages in a well-diversified portfolio that serves the true cash flow needs of the investor,” says Thomas West, advisor and partner at SEIA in Tysons Corner, Virginia. “Investors should construct their portfolios to maximize the probability that their returns will cover inflation and their withdrawal needs, which sometimes means including more stocks than anticipated.”

Hedge your bets

Some investments are better equipped to bear inflation's brunt than others. Treasury inflation-protected securities or inflation-protected annuities can act as a natural hedge against rising prices, though they may work better for some retirees than others.

With TIPS, you’re protected against inflation because the principal and interest adjust with the CPI, Cintorino says, but you should consider the duration risk. If you must sell before maturity, the market value of these bonds could fall, and you forfeit any inflation adjustment, which is paid only on maturity.

Steve Azoury, owner of Azoury Financial in Troy, Michigan, says a lifetime income annuity can be more effective combating inflation and stock market fluctuations, as well as helping you prepare for unforeseen medical expenses or life events.

With these annuities, you surrender future access to a portion of your savings in exchange for a lifetime stream of guaranteed income. “Inflation concerns can be addressed by using a variable annuity with a guaranteed lifetime withdrawal benefit to keep up with rising prices,” Azoury says.

Like stocks, it’s important to have the right exposure to inflationary hedges. Bill Van Sant, senior vice president and managing director at Univest Wealth Management, based in Souderton, Pennsylvania, says TIPS shouldn’t be a core holding when inflation is rising. He advises limiting your portfolio's overall exposure to a low single-digit percentage.

With inflation-protected annuities, the primary concern is cost. “Is the initial cost going to hurt the benefit that it’s trying to provide? That’s something you have to consider,” Van Sant says.

Consider health care costs

Investing strategically can help curb some of inflation’s effects, but it’s only one piece of the puzzle. You also should consider how you’ll handle mounting medical expenses and when it makes sense to tap Social Security.

Peck says a health savings account is one option for countering health care costs later in life. HSAs are associated with high-deductible health insurance plans. Funds can be withdrawn from these accounts tax- and penalty-free for medical expenses. After age 65, you can withdraw HSA money penalty-free for any reason, but you will owe ordinary income tax on those withdrawals.

The money you save in an HSA can be invested in stocks, mutual funds and other securities, offering more opportunities to fuel growth in your portfolio. Having this extra cushion in reserve can help you keep more of your investments intact in tax-advantaged retirement accounts or taxable accounts as you age.

Long-term care insurance is another tool for protecting retirement wealth against higher health care expenses. The insurance covers long-term nursing home care, an expense that Medicare won't pay for at all and that Medicaid won't begin to pay for until you've exhausted your own assets.

When it comes to Social Security, it’s all about the timing. Take benefits before full retirement age and your monthly benefit is reduced. Wait until age 70 and the benefit amount is greater. 

That strategy, however, won't help you address inflation because the larger benefit won't be enough to offset rising prices. “The incremental growth in benefits is going to pale in comparison to the actual rise in costs for living expenses and health care, so retirees have to plan elsewhere,” Van Sant says.


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