Inflation is Here – What Do We Do?
Kevin Michels, CFP®, EA
Inflation is Here – What Do We Do?
Inflation is here.
From October 2020 to October 2021 the Consumer Price Index rose 6.2%. We’re not used to this; the last time inflation was at 6% was in 1990.
We’ve seen the biggest jumps in energy (gasoline, oil, services) and used cars and trucks. But across the board inflation is ticking up.
Some of us feel it more than others. If you’re shopping for a home or car, or have a long commute, inflation is very real and you’re most likely feeling the effects.
For someone like me, who has a very short commute to work each day and isn’t in the market for a home or car, inflation hasn’t been that noticeable, aside from slightly higher prices at the grocery store.
In any case, it seems inflation is here to stay, at least for now, and one of the most common questions we’re getting from clients is, “What do we do about it?”
As is the case for everything in financial planning, the answer is, “it depends”. From an investment standpoint, we’ll break down the answer to this question in three categories. What should you do with short-term savings, intermediate-term savings, and long-term savings?
Short-Term Savings
We look at short-term savings as money you plan on spending in the next 1-4 years.
The highest priority for short-term savings is principal protection. Second highest priority is liquidity. Short-term savings should be invested in vehicles that guarantee principal and pay a fixed or variable rate of interest. You should be able to access the money as soon as you need it.
Typically, people keep short-term savings in a savings account, money market account, or CD. While these accounts are super liquid, rates are dismal. Currently, the highest rates we’ve been able to find are around 0.50% (Capital One Bank, Ally Bank, MARCUS). Essentially, over the past year, you locked in a -5.7% annual loss by keeping your short-term savings in a “high-yield” savings account.
However, that shouldn’t make you feel bad. Remember, the two highest priorities on short-term savings are principal protection and liquidity and both of those boxes are checked in a savings account. If you can compromise on the liquidity part, you have two more options:
Series I Savings Bonds
Series I Savings Bonds are issued by the Federal Government and purchased directly through their Treasury Direct website. The interest rates these bonds pay increase when inflation rises. Currently, they’re paying 7.12%.
While your principal is protected, they aren’t as liquid as a traditional savings account. You must hold the bonds for a minimum of one year. After one year they can be redeemed, but you’ll lose 3 months of interest if you redeem them within the first 5 years. Even if you do redeem early, you’ll still end up earning much more on a Series I than you would in a savings account. For example, say you put $10,000 in Series I bonds. You hold the bonds for one year and then redeem them. Your net interest after your forfeiture is $525. Compare that to keeping your $10,000 in a savings account paying 0.50% interest. Your interest for an entire year would be $50.
Also keep in mind you can only buy $10,000 per person in Series I Bonds each calendar year.
Multi-Year Guaranteed Annuities (MYGA)
MYGAs are fixed annuities that offer a guaranteed fixed interest rate for a certain period. Typically, they’re offered on a three-to-ten-year term. For purposes of short-term savings, 3-year MYGAs can be an effective tool. Like Series I Savings Bonds, your principal is protected, you receive a stated rate of interest, and they aren’t as liquid as a savings account. Some MYGAs may allow you to make early withdrawals but they typically come with a surrender charge. Current rates on 3-year MYGAs are around 2% - 2.5%.
Intermediate-Term Savings
We look at intermediate-term savings as money you plan on spending in the next 5-9 years. With this slightly longer time horizon, you can take on a bit more risk with your investments. Typically, we’d invest this money in high quality bonds and maybe a little bit of stock. However, 5-year government bonds are only paying 1%, 10-year government bonds are only paying 1.5%, and corporate bonds are only paying about 2.25%.
Even at lower rates, we still include these bonds in a portfolio because they provide a great ballast and stability during stock market turmoil.
We’ve recently added Treasury Inflation-Protected Bonds (TIPS) to our portfolios to mitigate the negative effects inflation can have on bonds.
Treasury Inflation-Protected Bonds (TIPS)
TIPS are bonds issued by the government that include an extra component on top of the interest rate they pay. When inflation rises, so does your principal for purposes of determining the interest payment you receive.
For example, say you invest $50,000 into TIPs paying 2% interest. Your annual interest payment is $1,000. Now, assume inflation goes up by 10%. For purposes of determining your interest payment, the 2% interest rate will be paid on $55,000 instead of $50,000 (a 10% increase). Your interest payment will go from $1,000 to $1,100.
Long-Term Savings
We typically invest long-term savings in higher risk investments that provide a greater expected return over the long-term. Long-term investments that do well during inflation are stocks, real estate, and commodities.
Stocks
Companies can offset rising costs by increasing the prices on their own products and services. Therefore, corporate earnings will typically rise along with inflation. We never recommend having more in stocks than your risk tolerance or capacity calls for, but with proper education, and a sound investment plan in place, it can make sense to be overweight stocks during inflationary periods.
Real Estate
As we’ve seen first-hand, real estate can be a great investment during inflationary periods. When inflation rises, real estate prices rise, and new interest rates ris. Having a fixed low-rate mortgage can be a great arbitrage. With home prices up 20% year-over-year, having a 3% mortgage isn’t a bad deal.
Investors who own property directly or through an investment that pays rental income also benefit from inflation. In additional to appreciation on the actual real estate, rents are increased to keep pace with inflation.
Commodities
Commodities include things like crude oil, gas, crops, and precious metals. Simply put, commodities are needed to produce most goods and services, and so when inflation takes off, so do the prices of commodities. Commodities can have a place in a diversified portfolio, but they’re very volatile, and have gone through multiple long stretches producing poor to negative returns.
Honorable Mentions
Gold
Historically, gold has been noted as a great investment to hedge against inflation. And in certain time periods it has. Maybe 2021 is an anomaly, but from October 2020 – October 2021 when inflation rose by 6%, gold was down -6%. One theory has been that crypto currency has replaced gold as an inflation hedge.
Crypto Currency
In my opinion, crypto currency is here to stay. If businesses and people continually adopt it as a means of payment, the investment value of crypto will most likely continue to rise. On the other hand, even though Bitcoin is up 350%, it seems too early and difficult to tell whether that rise had anything to do with inflation.
Bottom Line
Inflation is here, but that doesn’t mean you need to make drastic changes to your portfolio. For short-term savings, consider sacrificing some liquidity for higher interest rates. For intermediate-term savings, consider allocating a larger portion of your bonds to variable rate and inflation protected securities. And for long-term savings, stay heavy on stocks if your risk tolerance and capacity call for it.