A last life of Allianz survey found that more Americans see inflation as the biggest threat to their retirement than any other money concern, but advisers, on average, are three times less likely to worry about inflation than their clients. If inflation is unchecked, it can be one of the biggest destroyers of financial wealth and dreams of clients. Here are six impactful ways to help customers gain more peace of mind in inflationary times.
1. Help clients calculate their “personal inflation” rate. Every customer spends money differently. A 65-year-old retired couple in the suburbs may have two heavily used cars and the associated costs of insurance, repairs, and gas. In contrast, a 65-year-old couple in the city, of the same age, income and health, may not own a car or only use it for weekend getaways. The price of new and used vehicles, repairs and insurance have increased dramatically since the pandemic and will significantly affect their budget. City dwellers will not feel this inflation as the suburbs will.
You can add significant value by helping clients determine their inflation rate based on how they actually spend money. This may require the car-dependent couple to choose between increasing their spending to maintain their current lifestyle (and reducing their current plan's chances of success) or decreasing their lifestyle to maintain their the same level of expenditure. Housing costs are another example. If a couple has a fixed-rate mortgage, their housing cost is impervious to inflation, except for increases in property taxes, utilities and repairs. On the other hand, tenants will face the constant pressure of rising rents plus the cost of utilities. Your personal inflation rate will make a big difference.
2. Pay more attention to collecting money. With so much uncertainty in the world today – and money markets paying over 5% – you may see clients with more than six to 12 months of living expenses sitting idle in cash. You need to have a conversation now because their wealth is being quietly eroded in the name of peace of mind.
One way to do this is to list your client's goals for their money. For example, they may want cash on hand for unexpected emergencies, a travel fund, or savings for a down payment on a home. You can then help your client determine how much they need for each purpose. If the emergency fund goal is based on the client's living expenses (for example, six months' worth), you can help the client go through their budget or expense tracker to come up with a reasonable number (and ensure that it is in line with the client's current level of expenditure, as some living costs are likely to have risen due to inflation).
3. Pay more attention to “sequence of returns” risk. In one the last article, I discussed the risk sequence. In addition to this issue, there is the problem of increasing the distribution of income to cover the rising cost of living. One problem with many retirement planning software programs is that they tend to set a constant inflation rate (say 3%) over the entire retirement time horizon. Inflation rates vary widely over a multi-decade retirement. However, if there is an increase in inflation early in retirement (as those retiring in 2022 and 2023 can attest), pulling more income out of the portfolio can destroy your client's long-term retirement security . If there is an inflation rate of 10% in year 1 of retirement, the long-term impact will be felt for many years. This first-year inflation rate affects each subsequent year of spending. So it would have a bigger impact on your retirement plan than if a big spike in inflation happened in year 15 or year 20.
Studies from my American College colleague, Dr. Wade Pfau, demonstrate that not accounting for inflation when determining sustainable withdrawal rates from a retirement portfolio can lead to premature asset depletion. Pfau's research suggests adjusting withdrawal rates downward (to 2.4% from the traditional 4%), or using inflation-adjusted withdrawals to mitigate this risk.
Think about what that means. A $1 million portfolio that can distribute $40,000 (4%) per year can be reduced to $24,000 per year in distributions based on Dr. Phew. If your client is 40 years old, that changes the savings trajectory. But what if your client is 65 or 70 years old? There is not much time to add enough assets to solve this problem.
4. Expand the discussion of means of fighting inflation. Many advisors may not adequately diversify their clients' portfolios to include inflation-protective assets, such as Treasury Inflation-Protected Securities (TIPS), I-Bonds, and real estate investment trusts ( REITs). Consider the age of your customer and the impact that lower returns will have if they are younger. You may want to consider alternatives to increase your fixed income portfolio's return.
TIPS are very useful for protecting against future increases in inflation. Unlike traditional bonds in which principal and interest payments are generally fixed and thus can be eroded by inflation over time, TIPS are designed to be equivalent in inflation-adjusted value from the date the bonds are issued. issued to maturity.
Series I savings bonds, in addition to paying a fixed interest rate determined by the Treasury, also pay a variable inflation-adjusted rate, determined by changes in the inflation rate measured by the consumer price index. For example, I bonds issued between May 1, 2023 and October 31, 2024 will have an interest rate of 4.28%, which includes the rate set by the Treasury Department, 1.3%, plus the variable component based on the rate of inflation. Remember, there's generally a purchase limit of $10,000 per year, and I-bonds must be held for at least one year, so customers won't be able to cash them out before the end of the year if the rate drops for due to the drop in inflation. . They will lose the last three months' interest if you repay them before the five years are up.
REITs have a relatively consistent track record of outperforming inflation and have outperformed stocks in periods of moderate and high inflation. However, REITs have their drawbacks. Many REITs are illiquid, have high expenses, and may present tax complications that may or may not outweigh the benefits of inflation protection.
5. Don't forget about the good old stocks. Stocks have proven to be among the most inflation-resistant investments. Stocks (as measured by the S&P 500) have generated an average annual return of 10.2% from 1926 to date, yielding an inflation-adjusted return of +7.10% per year. For clients inquiring about adding inflation-hedged assets to their portfolios, remember to look at the inflation-hedged holdings of stocks they already own. For example, a younger client with a portfolio comprised of 80% to 90% stocks—and a 30-plus year retirement time horizon—may already be well protected against inflation without adding other inflation-defying assets.
For older clients with a shorter investment horizon and presumably a smaller allocation to stocks in their portfolio, explain the difference between:
- Long-term inflation protection of their savings (which can be provided by stocks or equity funds they already hold), versus
- Inflation protection for their income in the short term (which may include assets with a more direct short-term correlation to inflation, more on which below)
The selection and management of a portfolio is a balance between: (1) safety and stability; (2) Inflationary pressures; and (3) Demographics (for example, age, geography, and relationship status).
6. Help clients avoid “bracket creep.” While tax brackets are theoretically indexed to inflation, your higher-income clients may be especially susceptible to bracket creep. If their income (including pension income) rises faster than the limits for each tax bracket, more of their income falls within the higher tax brackets, causing them to be taxed at higher tax rates effective. Bracket creep gets worse when state taxes are factored into the equation. This means that in those states, any increase in income is likely to result in higher effective tax rates.
You can help clients take advantage of tax planning opportunities such as “pooling” charitable donations together or switching from Roth IRAs to traditional IRAs or 401(k) contributions. These can ease the effects of higher taxes, especially when higher costs due to inflation are already eating into their incomes. Another tax planning opportunity stems from the fact that some parts of the Internal Revenue Code are not indexed to inflation, such as the $10,000 state and local tax deduction, the $250,000 modified adjusted gross threshold that triggers the $3,000 threshold dollars for capital losses that are deductible against ordinary income.
Dr. Guy Baker is the founder of Wealth Teams Alliance (Irvine, California).