Inflation Protection: How Much Do You Need?

If you were to survey a group of sophisticated investors about what's keeping them up at night right now, inflation wouldn't likely receive many mentions, let alone top their lists.

Rising interest rates, high valuations, the prospect of slowing growth in developed and developing markets, deflation? Absolutely. Inflationary pressures? Not so much. And it's true that the data on inflation look remarkably benign. Energy prices, in particular, have kept inflation, as measured by the Consumer Price Index, muted. And while core inflation--which excludes volatile food and energy prices--ticked up in February, it was still below the Fed's 2% target.

Bob Johnson, Morningstar's director of economic analysis, agrees that inflation isn't cause for concern in the near term, but he thinks it's a bigger threat over longer time horizons. And if inflation is a concern over the long haul, it's better to add protection to your portfolio now, when inflation hedges are reasonably priced or perhaps even undervalued, rather than waiting until inflation is apparent and the demand for inflation hedges spikes upward. (I discussed the topic of whether Treasury Inflation-Protected Securities are undervalued in this article.)

To be sure, one of the key goals for all long-term investors should be to out-earn inflation: From that standpoint, making sure that a portfolio is set up to defend against inflation should be a key motivator for all investors. But not everyone needs significant exposure to investments with more direct inflation-hedging characteristics, such as Treasury Inflation-Protected Securities, commodities, precious metals, and real estate securities.

Answering the following questions can help you determine your own need for inflation protection in your portfolio.

What's Your Investing Life Stage? Accumulating/many years until retirement: Less inflation protection In or close to retirement/drawdown: More inflation protection

Investors who are still drawing a salary have a bulwark against inflation on two fronts. Their wages will trend up over time as prices advance, thereby preserving the purchasing power of their salaries. They're also apt to have more of their portfolios staked in stocks than will investors who are in or close to retirement-drawdown mode; stocks stand a good chance of out-earning the inflation rate over time.

Meanwhile, retired (or soon-to-retire) investors who are drawing at least a portion of their income from their portfolios have a much greater need for inflation protection. While parts of their in-retirement income streams may have built-in inflation protection, such as Social Security or a government pension with an inflation adjustment, the portion of their income that they're drawing from their portfolios does not. That's a particular concern for retired investors with a portion of their portfolios staked in investments with fixed interest rates, such as cash and bonds. If inflation ticks up, the investor who's drawing upon fixed-rate investments would see a real decline in her purchasing power, unless she also took steps to inflation-adjust that income stream. That's the reason that Morningstar's Lifetime Allocation Indexes--and most target-date fund series, for that matter--include little to nothing in inflation hedges like TIPS for young accumulators and substantial allocations for those nearing drawdown mode.

What Does Your Asset Allocation Look Like? More stock-heavy: Less inflation protection More bond/cash-heavy: More inflation protection

Historical market performance sends a mixed message about the correlation between rising inflation and a rising equity market. While it seems like there should be a connection, in that inflation is often a sign of an improving economy and the market likes economic growth, a countervailing force is that the higher input costs that result from inflation are a headwind for many types of companies--from packaged-food makers to automakers.

That said, stocks have a better shot of out-earning inflation over long periods of time than any other asset class, especially given today's paltry starting yields on bonds and cash. From that standpoint, portfolios with heavier equity weightings have less of a need to add in direct hedges against inflation than ones with sizable allocations to fixed-rate investments like cash and bonds.

Of course, in most cases, the amount of equity exposure in a portfolio correlates with one's life stage, but that's not true in every situation. For example, retirees who are able to get by on Social Security and/or a pension--and are, therefore, drawing very little cash from their portfolios--are apt to have much more in stocks than retirees who are drawing most of their income from their portfolios.

What Does Your Equity Portfolio Look Like? More wide-moat stocks: Less inflation protection Fewer wide-moat stocks: More inflation protection

Although stock performance--in aggregate--isn't correlated to the inflation rate, some types of stocks may, in fact, behave better in a rising-inflation environment than others. Because their competitive advantages give them more of an opportunity to pass through any increases in input prices to consumers, wide-moat stocks should hold up better than narrow- and no-moat companies in an inflationary environment, as discussed here. Premium Members can see the moat ratings for individual stocks on the Quote and Analysis tabs; fund investors can click on the "Premium Details" view of the Portfolio tab to view the percentage of each portfolio that rates as wide, narrow, or no moat. For example,

Do You Have Substantial Inflation-Protected Retirement Income Streams? Yes: Less inflation protection No: More inflation protection

As noted earlier, working people who are earning salaries generally receive cost-of-living adjustments to their paychecks. For many, much of that purchasing protection goes away when they retire. But some investors have substantial inflation-adjusted sources of income that will follow them into retirement, too. Social Security is one income source that ratchets up its payout to keep pace with inflation; many pensions, particularly in the public sector, are also inflation-adjusted. Investors can also buy annuities whose payouts adjust upward with inflation--though, of course, they'll pay more for such a product than they would for a non-inflation-adjusted annuity. The bottom line is that the more your in-retirement cash flow needs are met with these types of inflation-protected income sources, the less need you'll have to add explicit inflation protection to your portfolio. (If you're lucky enough to have most of your income needs met through these guaranteed, inflation-adjusted income sources, that will also mean that you can hold more of your portfolio in stocks.)

What Does Your Consumption Basket Look Like? Inflation is low for my consumption basket: Less inflation protection Inflation is high for my consumption basket: More inflation protection

Another important dimension of this discussion is what you intend to spend your money on; your own inflation experience may be better or worse than what's reflected in the Consumer Price Index. An extreme example is the investor saving for college: With college tuitions rising much faster than the general inflation rate over the past several decades, the college saver should not only be concerned about inflation but should also look beyond inflation hedges like TIPS, whose inflation adjustments are linked to CPI. To out-earn the college-inflation rate, college savers need to be invested in higher-returning assets like stocks, at least when the prospective college student is young.

Calibrating the right amount of inflation protection is more complicated for retirees who expect to use their portfolio income to fund a broad swath of expenses. This article provides historical inflation rates for many of the line items in retiree budgets, from health care to housing and food. Taking a close look at your own consumption basket, and the inflation historically associated with each line item, can help you determine how concerned to be about inflation taking a bite out of your purchasing power.