Inflation is frequently mentioned in the news and particularly by the financial press. Lately we’ve heard about inflation connected with many products and services as we emerge from the pandemic. Inflation is often linked with Federal Reserve policy as well.
Inflation is a key variable to consider in your financial planning, especially for those nearing and in retirement.
Inflation is generally defined as a loss of purchasing power due to increases in the cost of various goods and services in the economy. Inflation is often discussed in terms of the Consumer Price Index (CPI). This is a measure of the price increases of a specific basket of goods and services that is used as a proxy for the entire economy.
The problem with CPI or similar inflation benchmarks is that this is not representative of everyone’s situation. Different types of goods and services are impacted in different ways by inflation and at different times. At a personal level, the impact of inflation on your situation is a function of the specific goods and services you consume.
In some periods, the supply of money set by the Federal Reserve may outstrip the growth in supply of some goods and services. This is a situation where there is too much money chasing too few goods. There is more money in the hands of many people and they want to spend it. If the supply of the goods and services they want hasn’t grown in proportion with the money supply, this can cause inflation as these consumers use their extra cash to bid up prices.
Inflation that is based on supply and demand is different. The inflation may be based on a lack of supply relative to the demand for a product or service. As we’ve begun to emerge from the pandemic, we’ve seen a shortage of workers in many industries. This has led to wage inflation in some cases as restaurants, airlines and other employers are forced to pay up to be able to hire the workers they need.
Many of the products and services used by retirees have been hit inordinately hard by inflation in recent years. As a case in point, take the price of prescription drugs and healthcare. These costs have risen at a higher rate than the general rate of inflation that might be reflected in an index like the CPI. Another area that has seen dramatic price increases over time is the price of long-term care and related services.
Inflation in these and other critical goods and services frequently used by retirees comes against a backdrop where retirees are often on a fixed or semi-fixed income. Their portfolios may be invested in a fashion to minimize downside risk that may not fully keep pace with the inflation on the basket of goods they normally consume.
Sources of income such as a pension or Social Security may offer minimal or no cost of living adjustments (COLA). For example, most private sector pensions do not offer any COLA increases. Public sector pensions and Social Security do offer COLA adjustments, but these inflation adjustments are often based on a benchmark like the CPI which doesn’t reflect the true impact of inflation on the goods and services used by retirees.
Inflation is a function of supply and demand. If something is in short supply but there is a high demand for it, the price will likely increase. As we come out of the pandemic we are seeing many examples of this.
The housing market in many areas of the country is hot. We’ve read about instances where home buyers are bidding on homes without ever seeing them in person. This is an outgrowth of the desire of many residents of major cities to move to desirable suburban areas with more space.
The price of many new cars has risen due to a shortage of microchips used in the manufacturing process for most modern day vehicles. This chip shortage has impacted a number of other industries and has helped to drive prices up in many cases. The cost of travel and related costs has risen as people long to go on a trip after being at home so much as a result of COVID.
Regardless of your age, it’s important that your investments generate returns that stay ahead of inflation. Asset classes like stocks, real estate, some commodities, precious metals and others have generally outpaced inflation over the long-term. For bond investors there are even inflation protected Treasuries (TIPs) where the interest rate is tied to an inflation benchmark.
For younger investors this generally will not be too much of an issue. Their portfolios should be weighted towards equites and other investments that can generate the types of returns. They have a relatively long time horizon until retirement, and they are young enough to weather the types of fluctuations that these types of investments might experience over time.
For those who are nearing or in retirement, this is where the right asset allocation is critically important. Investing in retirement is a balancing act between managing downside risk and taking enough investment risk to stay ahead of inflation.
Regardless of your age, a diversified portfolio is important. Holding assets that can serve as a hedge against inflation is a key component of your asset allocation at all ages. Some of the asset classes that serve as hedges against inflation also serve as solid portfolio diversifiers due to their relatively low correlation to asset classes like stocks and bonds. Examples include gold and other precious metals, commodities, and real estate.
Certainly investors want to minimize the potential for losses on their investments from a decline in the value of their holdings. Lost purchasing power due to the impact of inflation on your investments is another type of loss that you want to avoid as well.
We can help allocate your investments to provide protection against the impact of inflation. Give us a call to see how we can help you implement an investment strategy that is tailored to your unique situation.
Bill Canty, CFP®, CPA
Ed Canty, CFP®, Investment Advisor
Joe Canty, Investment Advisor
Maureen Walsh, EA, Investment Advisor
Tina Alteri, CPA, Tax Advisor
Ballston Spa: 518-885-3230
Naples: 239-435-0090
