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Will Fixed Income Fail as an Inflation Hedge in Retirement?

Seth Jentner09/28/2011

What do many investors who are about to retire or are in retirement worry about? They seem to focus on the stability of their principal.  This can be a big mistake.  Fixing the value of your portfolio at retirement (i.e. using fixed income investments in order to avoid temporary market “losses”) probably guarantees that you will not succeed financially in retirement.

The biggest financial foe you face over a lengthy retirement is not temporary stock market volatility; it is long-term erosion of the purchasing power of your income.  Consider the cost of a postage stamp 40 years ago. In the summer of 1972, first class mail cost just 8 cents. Today it costs 44 cents, an annualized increase of over 4 percent per year.

Today it’s impossible to put your money into just about any fixed-income instrument (except risky high yield bonds) with a rate anywhere near 4 percent.  In fact, a 30-year rally in bond prices has reduced yields on short-term bonds to nearly zero.  Meanwhile, consumer inflation is anything but zero. The current inflation rate, as measured by the Consumer Price Index, stands at 3.6 percent.  Although bonds kept up with inflation over the last 40 years, at current prices it is hard to believe they can over the next 40.  As interest rates increase, bond values decline.

The stock market, however, has done a much better job of keeping up. Over the last 40 years the Standard & Poor’s 500 Index has returned about 10 percent per year, despite dozens of small to large temporary declines in value.  The stock market also allows long-term investors to keep more of what they have earned. Interest on bonds and bank deposits are taxed at a taxpayer’s highest current regular rate.  Long-term capital gains on stocks, however, receive favorable tax treatment. The current rate is only 15 percent.

Remember to place the emphasis on the right objective:  retirees need to preserve their purchasing power with a gradually increasing income.  Avoiding temporary market declines in one’s portfolio should not be the primary objective.  Focusing on the latter can be counterproductive to the former.