Don't Go Overboard With Inflation Protection

(MoneyWatch)  The most common question I get these days from retirees is "how do I protect myself from high inflation?" While inflation protection is important, if you only focus on inflation, you may be losing out on opportunities to produce more income today.

Low Rates. Many retirees are sitting on the sidelines in cash afraid to invest their money because they don't want to get whipsawed by inflation down the road. While this is a big concern, by sitting in cash, you're forfeiting the chance to prudently earn more income in today's markets.

• If you're in cash, you're probably making somewhere around 0.25 percent on your money.
• But if over the last year you'd been invested, for example, in a bond portfolio that was designed to track the Barclay's U.S. Aggregate Bond Index, you'd have received a little more than 4 percent interest on your money. This index is a mix of intermediate term Treasury, U.S. agency and high-quality corporate bonds.
• While 4 percent isn't great, it's 16 times more than what you may have been earning in cash.
• Let's assume you sit in cash for two years waiting for inflation, and the interest rate environment doesn't change. Well, you've earned about 0.50 percent from your cash over two years when you probably could have earned about 8 percent if you were more fully invested. So that's a real opportunity cost.

Distributions. Now, let's assume you need to take distributions from your accounts because you're retired. If you want to take 4 percent this year, and are only earning 0.25 percent, this means you're eating up 3.75 percent of your principal. If this continued for two years, you'd eat up 7.5 percent of your savings.

• But if you were more fully invested and earned more interest, you could distribute the income payments, which would lessen the need to touch the principal.
• If you're retired, you need to balance the risks of generating current income to feed distributions versus the threat of inflation down the road.

TIPS. You may be familiar with Treasury Inflation Protected Securities (TIPS), and they're a very good long term inflation hedge. But the problem with TIPS today is they don't produce much income for you to live on. So if you load up on TIPS and we don't get high inflation, or it takes years for inflation to emerge, you may be forced to spend more of your principal to pay the bills.

Flexibility. As long as you keep your fixed income holdings flexible, you should be able to respond to inflation by eventually buying bonds that provide higher income, while still earning more income today.

• One of the best methods is to simply ladder your holdings, meaning you have some bonds coming due every few years. This way if rates rise, as your bonds mature, you can reinvest at higher rates. But in the meantime, you're getting paid more today.
• You can ladder with individual holdings or also look into using some high-quality, passively managed bond ETFs. Many bond ETFs are targeted to a certain maturity range, such as short or intermediate term bonds.
• Remember, the return you want on bonds is the income return from the interest payments. Laddering provides a very simple and effective method to capture those interest payments without requiring you to time interest rate changes.

Dividends. And don't forget that one of the better long term inflation hedges has been a growing dividend stream from a diversified stock portfolio. Usually, stock dividends grow at a pace faster than inflation over the long term. So any increasing dividends will also help to offset inflation down the road.

• While dividend payments are not guaranteed, there's a reasonably high probability that your dividend payments will outpace inflation through your retirement years.

Bottom line. Inflation protection is important, but it's not the only thing retirees need to be concerned about. Be prepared to deal with inflation down the road, but you should also consider prudent strategies for generating more interest in today's environment.

As with all financial matters, consult your individual financial advisor prior to making any decisions.