With inflation expectations on the rise, now is a good time to consider what strategies you might implement for your retired clients to respond to a possible upturn in inflation. Surprisingly, a passive approach to income planning just may do the trick.
If inflation runs at its historical average of about 3%, a retired client's purchasing power will be cut in half in 23 years. If it jumps to 4%, the purchasing power is cut in half in 18 years. Therefore, to maintain purchasing power, advisers should have a basic strategy in place to allow for the client's income stream to grow throughout retirement. To get a sense of how you might address inflation, it helps to review prior inflationary cycles.
During the last significant inflationary cycle from the mid 1960s to 1980, inflation went from about 1.2% in 1964 to approximately 12.4% in 1980. This inflationary spiral certainly would have wrought havoc on a retiree's income stream.
But at the same time, the yield on intermediate-term government bonds rose from about 4% in 1964 to about 14% in 1983. Thus, a simple laddered bond strategy would have allowed a retired investor to continue to reinvest fixed income proceeds at higher rates over a 20-year cycle. While the increase in bond yields lagged the increase in the inflation numbers in the early years, once inflation had set in, the fixed-income market responded.
The second inflation-fighting tool that investors often overlook is potential dividend growth. For the 20-year period from 1964 to 1983, when inflation ran at an annualized rate of about 6.1%, dividends for the S&P 500 grew by 5.9%. As with bond yields, the dividend growth rate did not correspond on a year-to-year basis with increases in inflation. But over the 20-year cycle, dividends grew and provided an increasing income stream for investors to use as a source of distribution funding.
For the sake of illustration, assume a retired investor had a $1 million retirement account, with a basic fifty-fifty stock/bond allocation beginning in 1964. The yield on intermediate-term government bonds was about 4% in 1964, and the dividend yield on the S&P 500 was about 3%. Thus, the cash flow on the bond allocation would have been about $20,000, and the cash flow from the stock allocation would have been about $15,000.
Over the next 20 years, intermediate-term government bond yields rose from 4% to about 14%. Assuming the bond portfolio simply remained at $500,000, the interest payments on the bonds would have grown from $20,000 in 1964 to a range of $55,000 to $60,000 by 1983 using a laddered portfolio. The dividend cash flow from the stock allocation grew as well, from $15,000 to about $47,000. Thus, total cash flow would have grown from $35,000 in 1964 to around $102,000 to $107,000 by 1983. Interestingly, the growth in cash flow over those 20 years works out to about 5.6% per year, approximately the inflation rate during those years.
While past performance is of course no guarantee of future returns, historical cycles are instructive when attempting to decide how to manage inflation risks for retiree accounts going forward.
In fixed-income markets, simple discipline and patience may be all that is necessary. The discipline comes in structuring a laddered portfolio for the client and recognizing that you cannot time interest rates or inflation moves. The patience comes in recognizing that if inflation does settle in, eventually bond yields should respond.
Moreover, advisers have an additional inflation fighting tool with the emergence of Treasury inflation-protected securities in the late 1990s.
On the equity side, companies often have a difficult time responding to inflation at first, but if higher inflation looks permanent, companies eventually adjust their pricing. As the adjustments occur, profit margins often return to their longer term trend, and dividends generally increase. A strategy focused on high-quality, dividend-paying companies may provide a significant inflation hedge for your retired clients' income streams.
Charles J. Farrell is an investment adviser with Northstar Investment Advisors LLC in Denver. His column, On Retirement, appears regularly at investmentnews.com.
