Protecting Your Portfolio from Inflation

Last week, I wrote about some ways to potentially protect your retirement from rising inflation but we didn’t get a chance to discuss how to protect your portfolio. Here are some options to consider: 

Inflation Protected Government Bonds

As bonds that are fully guaranteed by the federal government to keep pace with inflation, these are your lowest risk options and come in two flavors. I-Bonds are safer since they don’t fluctuate in price, pay more (currently 2.2%), and are tax-deferred. However, you can only purchase up to $10k a year on Treasury Direct (plus up to $5k per year with IRS tax refunds). You also can’t cash them in at all within the first 12 months and you lose the last 3 months of interest if you redeem then within the first 5 years.

The other option is TIPS or treasury inflation protected securities. These bonds range in maturities from 3 to 30 years and fluctuate in price if you want to sell them before they mature. For that reason, consider buying them directly instead of through a mutual fund so you can control when you sell them. You may also want to hold them in a retirement account since you have to pay a tax on the phantom income each year from the bonds increasing in price due to the inflation adjustment even though that adjustment isn’t actually paid out to you.

Inflation-Adjusted Annuities

The biggest downside to I-bonds and TIPS are their low yields, which are currently around 1-2% after inflation. Unless your income needs are very low relative to the size of your portfolio, that probably won’t be enough. One way to get a much higher income while retaining safety and inflation protection is to purchase one or more inflation-adjusted immediate annuities at retirement, a strategy that’s popular among many economists.

These annuities pay you an income guaranteed by an insurance company for the rest of your life. Unlike regular annuities, they also rise in value with inflation. As a result, the initial payments are lower.

However, there are a few downsides to purchasing an immediate annuity in general. One is that you typically lose access to your principal so at the very least, you’ll want to keep some cash outside of it to cover emergencies. Second, the insurance company backing the annuity could go bankrupt. Fortunately, annuity companies are typically reinsured by other insurance companies and there are state guaranty associations that provide some additional protection. But to further minimize this risk, stick to high-rated insurers and consider diversifying with more than one company if you exceed your state’s guarantee limits. Finally, there’s no potential for growth or to pass the principal on to your heirs (you can have the annuity continue paying out to your heirs for a fixed time period or for the remainder of a beneficiary’s life but your payments will be lower).

Real Assets

If you’re looking for growth and want to retain your principal (or are concerned that the CPI that the previous options are based on underestimates “real” inflation), consider diversifying a portfolio of stocks and bonds with “real assets” like commodities and real estate that have tended to do well with rising inflation — so well that their gains can help offset losses in other parts of your portfolio during these time periods. However, they are not guaranteed and can be quite volatile so experts generally recommend investing no more than 5-10% of your portfolio, although some have advocated having as much as 25% in real assets like gold. They can also be tax inefficient so keep them sheltered in retirement accounts.

Commodity Stocks

Another way to hedge against inflation is to invest in the stocks of commodity producers since they can do well as the commodities they sell rise in price with inflation. As stocks, their long term returns have been higher overall than commodities too. The problem is that they also tend to act more like stocks than commodities in other ways so they may not provide as much diversification.

There is no perfect solution since each approach has its own pros and cons. Do any of them appeal to you or do you have your own strategy to deal with the threat of inflation? Leave your thoughts in the comments section below.

 

 

 

 

 

 

 

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