How To Prepare For Inflation

While the recent economic data indicates inflation is under control, it doesn't mean investors should be complacent. With massive federal spending and deficits looming on the horizon, it's a good idea to think about how your retirement portfolio is positioned for a possible inflationary cycle.

The key to dealing with inflation is flexibility. Investors who really get hurt by inflation are those who have locked themselves into long term, low yielding fixed income securities, such as CDs, bonds and annuities. By long term, I mean securities that mature more than 10 to 15 years from now.

Now it's important to own fixed income securities -- you just want to own ones that won't get pummeled if inflation heats up down the road. The basic rule of thumb is that shorter is generally better when dealing with inflation.

If you own shorter term fixed income securities, as they mature and you get your money back, you can reinvest those proceeds at higher interest rates if inflation spikes upward.

Consider this example:

• Assume you buy a five year bond today that pays four percent interest.
• Now assume inflation picks up and three years from now interest rates rise to six percent for new five year bonds.
• All you have to do is wait two years, and when your four percent bond matures, buy a new five year bond at six percent.

During the last big inflationary cycle from 1964 to 1983, interest rates rose from about four percent to 11 percent on intermediate term U.S. treasury bonds. So if you didn't lock yourself into a bunch of low yielding bonds in the 1960s, you could have adjusted as rates rose over the next 20 years.

If you have bonds maturing roughly every year for the next decade or so, you'll have opportunities to trade up to higher paying bonds if we get more inflation later. And in the meantime, you're getting a fair rate of interest on your money for the current environment.

This is a simple strategy that is generally quite effective. It doesn't require you to time interest rates or inflation, and allows you to react to changing market conditions simply because you have the flexibility to invest new capital each year.

The other term for this strategy is a laddered bond portfolio. Sounds fancy, but it just means you stagger the bonds so something is maturing each year.

In addition to traditional bonds or CDs, the other option is to consider investing some of your retirement savings in Treasury Inflation Protected Securities (TIPS). These are U.S. Treasury bonds that are designed to go up in value with increases in the CPI.

TIPS are a little complex, but basically offer a good, long term hedge against an inflationary cycle, although they don't offer much current income. So if we don't get a lot of inflation, they may not seem like such a good bet. Remember, high inflation is only a possibility, not a certainty. So be careful about getting too concentrated in one type of holding.

Bottom line: Because of massive government spending, a high inflationary cycle is something that you should be prepared to handle. The key is to have a flexible fixed income portfolio. Consider having some bonds maturing every few years so that you can trade up to higher paying bonds if inflation rears its ugly head, and mix in a few TIPS as well.

As with all financial decisions, please consult your individual advisor before making any decisions.

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