Simple strategies for reducing inflation risk
One of my favorite movies is the 1988 action classic Die Hard. As much as I love the movie, one scene always has me shaking my head in disbelief. It’s when a police officer walks out of a convenience store and in the foreground is a sign: $0.77 for a gallon of gasoline!
That feeling you get when remembering how cheap things used to be? That’s inflation.
Among the numerous risks facing investors, perhaps inflation weighs most heavily on investors’ minds. But what’s the real impact of inflation? Is it a silent killer, slowly pushing a better lifestyle just out of reach, or is it a by-product of a growing economy and functioning marketplace? Should you take swift action to combat inflation, or merely accept it as part of investing?
The lowdown on high inflation
In a recent blog post, Vanguard Global Chief Economist Joe Davis stated that a return to the runaway inflation of the 1970s is not likely, but the chance of sustained rates above the 2% level is possible. Nonetheless, retirees should consider how higher inflation could impact their financial situation, how spending is affected by inflation, and the best actions to take against it. For example, does your budget mainly cover basic necessities like food and medicine, or do you have a little extra for luxuries? Depending on your answer, you’ll have different reactions to inflation risk and how you want to address it.
In short, the risk of inflation shocks is real. However, a real risk isn’t always synonymous with a detrimental risk.
Three questions on inflation
Isn’t inflation a major risk to the economy?
Not necessarily, as both the cause and severity of inflation matter. Consider how much you paid the last time you bought a cup of coffee. The price of coffee has increased over time, but why? If higher coffee prices are the result of more people wanting to indulge on lattes, that’s an example of good inflation. People have money to spend on freshly roasted coffee, and your portfolio has probably outpaced the increasing cost of caffeine. However, if a cup of coffee got more expensive because a truck of coffee beans tipped over on the freeway, that would be an example of bad inflation. Here, the cost of supplies is passed on to you without any economic or practical benefit in return.
Inflation is up 5% in the last year. How can that be good?
It’s important to note that everyone experiences inflation differently. You may read that inflation is up 5% from 1 year ago, but that doesn’t mean everyone spent 5% more on goods and services across the board. Certain items will be severely impacted, while others will stay closer to baseline assumptions.
If your consumption consists of at-risk items like gasoline, new/used cars, or travel, you probably felt the recent sting in inflation; those who are staying close to home probably haven’t seen much of a difference. Of course, that pattern won’t always be true (commuting costs won’t go up forever), but it helps illustrate that inflation isn’t some broad-based impact to all investors.
I’m uneasy about the impact inflation can have on my retirement. What can I do?
Investors have two options at their disposal to combat inflation risk: portfolio adjustments and spending adjustments. Portfolio adjustments include common inflation hedges like Treasury Inflation-Protected Securities (TIPS), commodities, and reduced bond exposure. Spending adjustments focus on rule-based approaches to keep spending in check (after adjusting for inflation).
While portfolio adjustments get more of the attention, spending adjustments are likely to be more predictable and more impactful over time. They also have the advantage of working in all market conditions—not just the ones we predict ahead of time.
Consider the case of a hypothetical couple, Jack and Diane. Both are 65 years old and retired at the start of 2021. They want to make sure their $1 million portfolio and $30,000 of combined annual Social Security benefits will support their planned lifestyle of $65,000 a year for the rest of their lives. Using Vanguard’s Capital Markets Model® (VCMM) to estimate possible return patterns from current market conditions, it appears that Jack and Diane were able to maintain their lifestyle through age 100 with a 94% success rate across 10,000 different scenarios.*
Now, let’s hone in on the 751 paths of “high inflation” (scenarios where cumulative inflation is greater than 20% in the first 5 years of retirement). Of the paths that met this criteria, Jack and Diane’s success at sustaining their lifestyle fell to 77%. To improve their odds of success, they might consider 4 options:
Option A: Do nothing.
Option B: Reduce spending after periods of poor performance (after adjusting for inflation).**
Option C: Invest 10% of equities into commodities and 10% of fixed income into short-term TIPS.
Option D: Use a combination of options B and C.
Table 1: Comparison of metrics by spending and/or investment strategy
751 high inflation scenarios represent 7.51% of the 10,000 possible scenarios tested for this hypothetical client.
Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of September 30, 2020. Results from the model may vary with each use and over time. For more information, please see the Notes section.
Source: Vanguard calculations, using baseline scenario from above. Client invests in a 60/40 portfolio, rebalanced annually. Inflation and portfolio returns determined by Vanguard Capital Markets Model® (VCMM) projections as of September 30, 2020. The benchmarks used were: US stocks: MSCI US Broad Market Index, Int’l stocks: MSCI All-Cap World ex-USA Index, US bonds: Bloomberg Barclays US Aggregate Bond Index, Int’l bonds: Bloomberg Barclays Global Aggregate ex-US (USD Hedged) Index, Commodities: Bloomberg Commodity Total Return Index, TIPS: Bloomberg Barclays US Treasury Inflation-Protected Securities 0-5 Years Total Return Index, Inflation: Consumer Price Index – Urban Consumers (CPI-U). The outcomes also assumed a 0.50% fee on prior year AUM to reflect potential advisory fees and fund expenses. A more detailed examination of the VCMM appeared in Davis, Joseph H., Roger Aliaga-Díaz, Harshdeep Ahluwalia, Frank Polanco, and Christos Tasopoulos, 2014. Vanguard Global Capital Markets Model. Valley Forge, Pa.: The Vanguard Group.
When looking at the 4 options side by side, it becomes evident that portfolio changes alone aren’t enough to mitigate inflation risk. TIPS tend to track short-term inflation with high predictability, but provide little inflation protection to the rest of the portfolio. Commodities, on the other hand, can provide a “spillover effect” for inflation risk by protecting more than the amount invested. However, their performance can be incredibly volatile and they’ve had bouts of underperformance in past periods of higher inflation. In short, neither strategy has proven to be a panacea in the face of inflation.
While adjusting your spending can extend the life of your portfolio in periods of high inflation, that doesn’t mean there won’t be trade-offs. Reducing spending helped extend portfolio life expectancy in all observed scenarios, but it did so with a lower real lifetime spending amount. However, small reductions in times of duress can increase the chance that one’s portfolio doesn’t run out prematurely; investors can choose to reset their spending levels to some degree or narrow their adjustments as they get past the storm.
The risk of inflation remains real and there are chances that short-term shocks can deviate from the long-run trajectory.
In most cases, minor adjustments to spending will be sufficient to navigate the choppy waters of inflation. And you can adjust your spending levels over time—you’re not necessarily locked into a spending limit forever.
It can be tempting to look at certain investment types as a cure, but they’re not without risk, and we believe the core principles of investing shouldn’t change. For the vast majority of investors, a well-diversified portfolio should continue to act as an “all-weather” portfolio that serves to combat (but not avoid) a number of market and economic shocks over the long-run. An advisor can help you determine how to allocate your assets to best address the impacts of inflation and other complex planning issues.
Lastly, remember that you don’t need to be perfect with your investment decisions—instead, aim to be consistent. Portfolios often sustain shocks, but emotional decisions can be more harmful than market risks could ever be. Take it from the person who researches these strategies every day.
Die Hard isn’t the only risky scenario I’ve seen over and over.
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*Actual success rate was 94.67%, or 9,467 scenarios, where Jack and Diane had at least $1 at age 100.
**Spending reduction never exceeds 2.5% of the prior year spending level after adjusting for inflation. To learn more about how dynamic spending works, please read our white paper From Assets to Income: A Goals-Based Approach to Retirement Spending (2020).
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Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
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IMPORTANT: The projections and other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
The VCMM projections are based on a statistical analysis of historical data. Future returns may behave differently from the historical patterns captured in the VCMM. More important, the VCMM may be underestimating extreme negative scenarios unobserved in the historical period on which the model estimation is based.
The Vanguard Capital Markets Model® is a proprietary financial simulation tool developed and maintained by Vanguard’s primary investment research and advice teams. The model forecasts distributions of future returns for a wide array of broad asset classes. Those asset classes include U.S. and international equity markets, several maturities of the U.S. Treasury and corporate fixed income markets, international fixed income markets, U.S. money markets, commodities, and certain alternative investment strategies. The theoretical and empirical foundation for the Vanguard Capital Markets Model is that the returns of various asset classes reflect the compensation investors require for bearing different types of systematic risk (beta). At the core of the model are estimates of the dynamic statistical relationship between risk factors and asset returns, obtained from statistical analysis based on available monthly financial and economic data from as early as 1960. Using a system of estimated equations, the model then applies a Monte Carlo simulation method to project the estimated interrelationships among risk factors and asset classes as well as uncertainty and randomness over time. The model generates a large set of simulated outcomes for each asset class over several time horizons. Forecasts are obtained by computing measures of central tendency in these simulations. Results produced by the tool will vary with each use and over time.