You don’t need an economics degree to know that inflation is a growing problem. Fueling up the car and buying groceries are sharp reminders of how hard-earned dollars are worth less when prices jump. Inflation affects everyone, but retirees are particularly vulnerable.
“The greatest risk retirees face is inflation, not short-term volatility of the stock market,” says Tom Orecchio, national chair of the National Association of Personal Financial Advisors. “People focus on the market today as opposed to their purchasing power 25 years from now, and that’s a mistake.”
These investments can help retirees protect against it.
How they work: TIPS are designed to protect investors from inflation by tying them to the Consumer Price Index, or CPI, the government’s main gauge of inflation. Specifically, TIPS’ principal rises with inflation and falls during deflation.
Consider: If someone buys $100,000 in TIPS and inflation increases by 3 percent, the TIPS principal will be worth $103,000 by the end of the year. (Adjustments are made every six months.) When TIPS mature, investors receive the original principal amount or one that’s been adjusted, whichever is greater.
TIPS also pay interest on a semiannual basis. This coupon rate is constant, but the interest earnings will fluctuate because it’s based on the inflation-adjusted principal. The interest every six months is computed by multiplying the principal by half of the coupon rate. So a $100,000 TIPS paying a 2 percent rate would pay $1,000 in interest every six months. (The principal’s growth is not factored into this calculation.)
Cost: TIPS are sold directly from the U.S. Treasury Department in increments of $100 as of April 2008. That’s down from a previous $1,000 minimum purchase price. Alternatively, you can purchase shares of mutual funds that primarily invest in TIPS, such as Harbor Real Return or Vanguard Inflation-Protected Securities. Minimum investment requirements and management fees vary from one fund to another.
Liquidity: TIPS are very liquid. You can sell them at any point in time, though there’s no guarantee you’ll make money. That’s because if you sell before the TIPS maturity date, “you incur a risk of selling at a premium or discount of what you’ve paid for it,” says Stephen Meyerhardt, spokesman for the U.S. Treasury’s Bureau of the Public Debt. The current interest rate environment affects the value of TIPS as well as most other types of bonds.
Pros: Inflation protection.
Cons: Taxes. Investors must pay ordinary income tax rates, which can be as high as 35 percent, for the interest they receive as well as for any increase in value in the TIPS principal. They’ll be taxed even if they continue to hold the TIPS. For that reason, experts recommend that TIPS be held in tax-sheltered accounts such as a 401(k) or an IRA.
Risk: In case of deflation, the value of the principal will go down. So if you sell it prior to maturity, you may get less than what you paid. You can avoid this risk by holding TIPS until they mature.
Lately, TIPS have been selling at a premium, due to consumer demand. That’s driven yields lower. For example, five-year TIPS fell to negative yields in recent months. Experts advise buying TIPS through a mutual fund. “The (fund managers) can scoop up new TIPS when more attractive yields appear,” says Paul Herbert, senior fund analyst at Morningstar.
Who they’re good for: Retirees, and anyone else living on a fixed income are good candidates for TIPS. But since no one is immune from the corrosive effects of inflation, Herbert recommends them broadly to both workers and retirees alike.
How they work: I bonds are a better hedge against inflation than plain-vanilla bonds because they’re designed to keep pace with rising prices.
Specifically, the bonds pay a composite interest rate that’s made up of two parts, an underlying fixed rate and an inflation-adjusted variable rate. The variable interest portion is tied to the CPI rate, the government’s measure of inflation, and rises and falls during the life of the bond to keep pace with prices.
The fixed rate portion remains unchanged for the life of the I bond. This rate changes semiannually, on May 1 and Nov. 1, for newly issued bonds.
Currently, I bonds are paying a composite rate of 4.84 percent. On May 1, the underlying fixed rate was set at zero percent, and the semiannual inflation rate was set at 2.42 percent. These rates will change again on Nov. 1.
“The fixed rate amount of zero percent is the lowest ever,” says Stephen Meyerhardt, spokesman for the Treasury Department. “That’s because the fixed rate reflects the underlying conditions of the short-term credit markets, where rates have dropped precipitously in the last six months.”
The semiannual inflation rate actually rose, to keep up with an uptick in inflation. That means the current composite rate isn’t at an all-time low. On the other hand, that’s not to say investors should ignore the fixed rate. Because it will remain unchanged for the life of the bond, anyone who buys I bonds in the next six months, before they’re reset in November, needs to be careful.
“They’re OK if you want to keep pace with inflation, but if your objective is to outpace it, these aren’t so good” right now, says Meyerhardt.
Cost: I bonds can be purchased electronically in amounts of $25 or more, or for a minimum $50 for paper versions, from Uncle Sam at www.treasurydirect.gov.
Liquidity: I bonds are not very liquid. You cannot redeem I bonds for 12 months, and if you sell before five years, you’ll forfeit interest from the three most recent months. To avoid penalties, you must wait five years to cash out.
Pros: Safety and inflation protection. Generally bonds won’t pay you the handsome returns of stocks. The upside? The principal is guaranteed.
Tax perks: I bonds are exempt from state and local taxes, and investors can defer what they owe in federal taxes until they cash them in.
Cons: Limited growth. Even though you beat inflation, I bonds generally won’t have the kind of growth as riskier investments. Lack of liquidity is also a negative.
Who they’re good for: Retirees who already have a hefty nest egg and therefore don’t need as much growth should look to I bonds. “I bonds can work for people who’ve worked hard for their savings and who want more capital preservation since they provide capital preservation as well as a bit of income,” says Morningstar fund analyst Paul Herbert.
How they work: As a rule, public companies either reinvest earnings or pass them along to shareholders as dividends. For individuals looking for a hedge against inflation, the second variety is hard to beat. That’s because dividend-rich stocks provide income, but unlike fixed-income investments, they have the potential for capital growth as well.
Large, established stocks, such as those in the Standard & Poor’s 500, have a greater likelihood of offering dividends. Nearly 80 percent of the index’s constituents pay cash dividends, versus just 39 percent of companies not listed on that index. Those paying the highest dividends are generally found in such sectors as industrials, utilities, financial services, pharmaceuticals and consumer staples.
Cost: Share prices vary depending on the company and market conditions. A commission is involved with the purchase of stocks, whether you purchase through a full-service brokerage firm or you’re a self-directed investor. Costs will be lower for the latter type of firm. If you buy a diversified mutual fund that focuses on dividend-rich stocks, you’ll pay an expense ratio.
Liquidity: Very liquid, in theory. You can buy or sell any dividend-paying equities at any time; however to reap lower tax benefits of qualified dividend distributions, individuals generally must own equities for a certain amount of time. That’s generally more than 60 days in a 121-day period surrounding the so-called ex-dividend date, which is the day after shareholders who are entitled to a dividend are identified.
“In other words,” says Mark Luscombe, principal tax analyst at CCH, “you can’t just buy the stock immediately before the record date and sell it after and expect the dividend to qualify for capital gain treatment.”
Pros: Low taxes — for now. Until 2010, qualified dividends are subject to capital gains taxes, which are no higher than 15 percent for individuals in tax brackets 25 percent or higher. (Individuals in lower tax brackets owe no tax on dividends starting in 2008 until Jan. 1, 2011.) Note: Nonqualified dividends — from REITs and preferred stock, for example — are subject to income taxes at ordinary rates. But generally, stock dividends are cheaper from a tax standpoint than income from bonds or TIPS.
The potential for capital appreciation with dividend-paying stocks, versus, say, the fixed value of a bond, means that these equities have the potential to keep pace with, or even surpass, inflation, while also providing a steady stream of income.
Cons: Besides the potential for capital loss, these stocks generally lack diversity. Dividend-paying stocks, or funds that invest in them, tend to concentrate on a few industries that aren’t known for rapid growth.
Risks: Equities can lose money, so buying dividend-rich stocks requires homework. “You have to be careful and do fundamental research because there are some really lousy companies that have big dividend yields,” says Christine Benz, director of personal finance at Morningstar.
If you’re leery about making a bad pick, consider turning to mutual funds that focus on dividends, such as Vanguard Equity Income or T. Rowe Price Equity Income. Warning: The performance of mutual funds is not guaranteed either, and values can go up or down.
Who they’re good for: Most retirees need the potential growth of equities, whether they pay dividends or not. After all, says Benz: “For someone who’s retired and will be living for another 20 years to 25 years, the risk of running out of money far outweighs the day-to-day volatility” of equities. But as seniors leave the work force, the added bonus of dividends is a smart choice for individuals who will need assets that provide both growth and income.
How they work: As their name suggests, ETFs have qualities of both stocks and funds. Though they’re composed of a basket of securities, they’re traded like a stock, so prices vary throughout the day. (Mutual funds are priced once daily.) But like mutual funds, ETFs can be composed of a pool of equities, bonds, commodities, currencies, derivatives, etc. ETFs are generally designed to mirror indexes, but that’s not always so. Some new products, like Invesco PowerShares’ line of Active ETFs, which came on the market in mid-April, are actively managed.
Demand for ETFs is fueling rapid growth in their offerings. It’s possible for inflation-leery individuals to find ETFs invested in high-growth stocks or dividend-rich equities.
Price: Varies throughout the day. Commissions are charged with purchases and sales.
Liquidity: Very liquid. You can trade ETFs as frequently as you want, just as with stocks. You can place limit orders on them, short them, buy them on margin.
Pros: Low management costs and rich yields. Because most ETFs are not actively run by a manager, ETFs are generally cheaper than a mutual fund. For example, a typical large-blend stock ETF costs 0.50 percent vs. 0.86 percent for the typical large-blend mutual fund, according to Lipper. A government bond ETF (including TIPS) generally costs 0.15 percent vs. 0.65 percent for the typical government bond mutual fund.
“They often have just half the ongoing costs of a mutual fund that holds similar assets,” says Jeff Tjornehoj, senior research analyst at Lipper.
Tax efficiency: There are two reasons ETFs are generally tax efficient. Generally, underlying assets in an ETF are pegged to an index, so they’re not traded as frequently as an actively managed mutual fund. And ETFs usually don’t make large capital gain distributions to investors either, keeping taxes in check.
“When market makers are creating and redeeming ETF shares, they can swap out low-cost basis shares of stock and, in so doing, lower the likelihood the fund will incur large capital gains,” explains Jeffrey Ptak, director of exchange-traded securities analysis at Morningstar. “Mutual fund managers don’t have the same mechanism to ensure minimal capital gains are passed to investors.”
Because there are hundreds to choose from, you can buy an ETF to suit your needs, be it a need to load up on high-growth stocks, dividend-paying value equities, inflation-proof TIPS or tax-friendly municipal bonds. Investors looking for a variety of dividend-paying stocks, for example, may consider Vanguard High Dividend Yield or WisdomTree Total Dividend ETFs.
Con: Transaction fees. Investors must pay commissions every time they trade an ETF, so they can wind up being pricey for active traders. And dividends that are reinvested in an ETF can be subject to brokerage commissions, too.
Risks: An ETF’s market price may skew widely from its net asset value. Though it’s uncommon, investors need to be aware this “adds a certain level of uncertainty,” says Ptak.
ETFs are often made up of a pool of assets in a narrowly defined index or in a particular sector. That concentration can increase the risk for price declines more than actively managed funds, which tend to have more diversification, says Christine Benz at Morningstar.
Who they’re good for: Relatively low management costs and tax efficiency make ETFs better for budget-minded retirees who are looking to invest a sum of money for years instead of weeks or months, and who may be seeking to diversify assets. They also offer a convenient, no-fuss alternative to individual securities since it’s “relatively easy to pick one off the shelf and plug it into a portfolio,” says Ptak.
How they work: Funds can be made up of a variety of underlying assets including stocks, fixed income, currencies, commodities and cash as well as a combination of these, depending on the style you choose.
A new breed of “retirement-income funds” is geared to nonworking seniors who want their assets to last for a specific number of years and keep up with inflation. For example, Fidelity Investments’ Income Replacement funds provide individuals with monthly payouts that are geared, but not guaranteed, to keep up with inflation while untapped assets remain under professional management. The goal of Vanguard’s line of Managed Payout funds is to help seniors strike a balance between generating capital growth and providing lifetime income. Schwab also recently announced new offerings.
Cost: Mutual fund prices and ongoing expenses vary. Actively managed funds are almost always more expensive than index funds. For example, actively managed value funds typically have expenses of 1.33 percent – nearly twice the average expense ratio of 0.68 percent for indexed value funds, according to Lipper.
Liquidity: If you own load funds, you may trigger front-end, back-end, deferred or other redemption fees when you sell. A short-term redemption fee, for example, is imposed on individuals who sell their fund shares within a certain amount of time, typically 30 to 60 days. Certified Financial Planner Brett Horowitz, a principal at Evensky & Katz Wealth Management, recommends individuals pick no-load funds, which are cheaper to trade.
Pros: Mutual funds are diversified and run by professional managers, eliminating worry for individuals who don’t have the time, expertise or desire to manage their investments themselves. This is particularly true with so-called target-date funds that automatically readjust holdings to become more conservative as someone approaches retirement.
Mutual funds invested in equities have the potential to keep pace with or surpass inflation, depending on their underlying assets and performance.
Cons: Expense. Ongoing management fees can make mutual funds pricy to trade, though some index funds run very cheap. Generally, fees eat into investors’ profits since they’re deducted from fund assets.
Actively managed funds with high turnover may generate high taxes.
Risk: Capital depreciation. Mutual funds come with no guarantees and may lose money, depending on the performance of their assets.
Who they’re good for: Funds are designed to achieve many different goals. For seniors looking for inflation protection or additional income, a mutual fund can provide more diversity for their investment dollar than purchasing, say, a single TIPS or dividend-yielding stock. Seniors who plan on a long retirement and who need to generate money after they leave the workforce, on the other hand, may also want to consider equity-based funds designed for growth. Any decision should be based on individual needs, risk tolerance and financial goals.