RISING PRICES AND YOUR SAVINGS
Inflation can significantly dampen the real returns produced by your investments and diminish your purchasing power over time. Consider that inflation has averaged 3% annually since 1926.3 At that rate, buying power decreases by half in 24 years. In other words, you could expect your expenses to double in a 24-year period, assuming your spending habits didn't change. Furthermore, average inflation rates do not reveal the negative impact that bursts of high inflation, such as the 13% rate in 1979, can have on a household's finances.
The buying power of workers may decline when inflation surges because wage increases often don't keep pace with rising prices. People living on fixed incomes—such as retirees—are especially vulnerable. Among couples that reach age 65, there is a 36% chance that one partner will live to age 95, according to the Society of Actuaries. Longer life spans magnify inflation's impact for two reasons: Inflation's effects compound over time; and longevity increases your chance of living through a period of high inflation. Those two considerations mean that inflation may be as challenging for retired investors as stock market volatility.
Your investment strategy should account for the impact of inflation on your savings over a long lifetime. First, it's important to hold enough stocks, which historically have offered the greatest returns of any asset class over the long term, exceeding the rate of inflation in every rolling 20-year period since 1926 (see the "Investing and Inflation" chart).4 Consider dividend-paying stocks, as well as natural resources stocks that generally benefit from rising prices. As always, be mindful that the stock allocation of your portfolio should also contain a diverse array of large-, mid-, and small-cap companies. Of course, diversification cannot assure a profit or protect against loss in a down market. Be sure, however, to have an adequate allocation of fixed income investments in your portfolio, and consider bond funds that can offer some protection against rising prices.
Consider the following investments as part of your overall portfolio to hedge against the effects of rising inflation.
FLOATING RATE FUNDS
Floating rate loans are securities typically issued by noninvestment-grade firms and usually offer more income than investment-grade bonds,
explains Justin Gerbereux, co-portfolio manager of the T. Rowe Price Floating Rate Fund (PRFRX). The yield on floating rate
loans can rise with interest rates, providing investors more income when rates rise. They are called "floating rate" loans
because the rates on these loans typically reset every three months. The interest they pay is tied to the general level of interest rates,
which offers a degree of protection against inflation: If inflation rises, the Fed is likely to increase interest rates—and higher
rates will cause the securities to pay more interest. Note that these funds could have greater price declines than funds that invest
primarily in high-quality bonds or loans; the loans and debt securities held by the fund are usually considered speculative and
involve a greater risk of default and price decline than higher-rated bonds.
TREASURY INFLATION-PROTECTED SECURITIES (TIPS) TIPS are Treasury bonds that have the full backing of the U.S. government and provide investors with returns that are adjusted based on the consumer price index. TIPS typically pay interest at a fixed rate, but the rate is applied to the adjusted principal, which means that from one period to the next, interest payments may increase or decrease. As inflation rises, TIPS' principal grows, which increases interest payments and payouts at maturity. Keep in mind that deflationary conditions (when inflation is negative) could cause the fund's principal and income to decrease in value. Yield and share price will vary with interest rate changes. Investors should note that if interest rates rise significantly from current levels, bond fund total returns will decline and may even turn negative in the short term. Unlike the Treasury securities in which the fund invests, an investment in the fund is not insured or guaranteed by the U.S. government.
T. Rowe Price NEW ERA FUND (PRNEX) Portfolio Manager Tim Parker invests in a wide range of commodities-related companies worldwide. Although 70% of the portfolio is domestic, the vast majority of its holdings have a global reach. "Being global lets us widen the net so we can look for best-of-breed, inflation-sensitive stocks in a variety of markets," he says. He also invests tactically, based on his outlook for a given commodity. He might select companies in particular sections of the commodities chain—emphasizing either oil suppliers or oil refiners, for example, to capture potential gains should oil prices rise. This fund may underperform when economic growth is slowing and the level of inflation is low. Because of the cyclical nature of natural resource companies, their stock prices and rates of earnings growth may follow an irregular path. Factors such as natural disasters, declining currencies, market illiquidity, or political instability in commodity-rich nations could also have a negative impact on various portfolio holdings and cause a drop in share prices.
T. Rowe Price REAL ASSETS FUND (PRAFX) Real assets is a broad category that includes assets with physical properties, such as energy and natural resources, real estate, basic materials, equipment, utilities and infrastructure, and commodities. Investors can gain exposure to these assets through stocks in companies, which often have a greater correlation with inflation than other securities. Over shorter periods, however, real assets stocks may be more volatile than other stocks, and investors are cautioned against concentrating their investments in this or other single asset classes.
T. Rowe Price RETIREMENT FUNDS Retirement date funds, often referred to as target-date funds, offer a simple alternative to trying to select the appropriate mix of stock and bond funds. Each professionally managed fund invests in a diversified range of T. Rowe Price stock and bond mutual funds. The asset allocation gradually becomes more conservative over time in order to dampen the fund's potential volatility and provide an income stream made up of regular withdrawals throughout retirement. The funds are designed to provide some protection against inflation by investing in securities that generally benefit from rising prices. These include energy and natural resources stocks, as well as real estate, basic materials, equipment, utilities, infrastructure, and commodities securities. Many of the funds also invest in TIPS and other inflation-focused securities.
1Mckinsey & Company, Mobilizing for a Resource Revolution, January 2012.
2Bureau of Labor Statistics, Consumer Expenditures, 2010.
3, 4Ibbotson Associates, Ibbotson® SBBI® 2012 Classic Yearbook.