Adding inflation protection to your portfolio, sensibly.
By Christine Benz | 06-01-10 | 06:00 AM | Email Article

I've been traveling a lot recently, speaking to investor groups and promoting my new book, 30-Minute Money Solutions. Traipsing through airports gets a little old after a while, but the best part about these trips is that I get to hear what's on investors' minds.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

One group I've been hearing from a lot lately is retirees and preretirees, many of whom are finding the current environment to be quite challenging, to put it mildly. With bond yields as low as they are, many retirees are complaining that it's next to impossible to generate a livable income stream from their portfolios.

To cover their day-to-day expenses, they're having to choose between tapping their principal or venturing into higher-yielding, but also riskier, securities such as preferred stocks. Neither is an especially appealing prospect. Others, meanwhile, are concerned about what could happen to their bond portfolios if interest rates were to jump up, a topic I discussed in a recent article.

And while inflation currently appears to be under control, retirees are also rightfully worried about the potential for rising inflation to gobble up their portfolios' future purchasing power. I usually recommend inflation-linked securities such as Treasury Inflation-Protected Securities as the most direct way to hedge against inflation.

But even investors who are convinced that TIPS are a good place to be long term still have questions about implementation. How much of a retiree's fixed-income portfolio should go toward TIPS or other inflation-linked bonds? And what about timing? If you buy TIPS at an inflated level (pardon the pun) and the bonds' prices sink shortly thereafter, do you erode any long-term benefit you hoped to gain from them?

The Importance of Being Inflation-Protected
I'll discuss these questions in a minute, but first it's worth fleshing out why a dose of inflation protection is so important for retiree portfolios. In large part, it's because retired folks miss out on some of the inflation protection that working people normally enjoy.

Paychecks will generally trend upward to keep pace with rising prices (maybe not right away and not for everyone, but over long periods of time and on average), but retirees don't have that safety net. True, Social Security payments are adjusted upward in an effort to keep pace with rising prices. But to the extent that a retiree is living off a portfolio anchored in fixed-rate investments, the payout from that sleeve of the portfolio will be just that--fixed. If prices go up, the purchasing power of that portfolio--and in turn the retiree's standard of living--goes down.

That's why inflation-indexed securities like TIPS, whose principal values adjust upward to keep pace with inflation, make so much sense as part of a retiree's fixed-income portfolio.

How Much Is Enough?
So assuming you've decided you'd like to include inflation-protected investments in your portfolio, what's the right amount? At first blush it might appear that you'd want all of your fixed-income portfolio in TIPS; that's the tack embraced by some academics and other investment theorists. After all, if there's a bond investment that helps offset the corrosive effects of inflation, why would you want to forgo it for one that doesn't offer that protection?

The key reason is diversification. While some corporate, foreign, and municipal bonds carry inflation protection, TIPS are the most widely available and liquid type of inflation-linked bonds, and most inflation-protected bond funds skew heavily or even entirely toward TIPS. That means an investor in search of an all-inflation-protected fixed-income portfolio would have to go out of his way to avoid a heavy emphasis on government bonds; at the same time, he'd hold relatively less in corporate, asset-backed, and other bond types, which will outperform Treasuries and other government-backed bonds at various points in time.

Securities mentioned in this article



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Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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