Life Notes Financial Health article by Brent J. Welch, CFP®, ChFC, CRPS®, CLU, AIF®
Inflation has averaged 4.2% the last fifty years according to JP Morgan investments Q4 ’14 Guide to the Markets. The Consumer Price Index (CPI) puts a heavy 41% weighting on housing, 17% weighting for transportation and 15% on food costs 8% on medical care and 6% on travel and entertainment. Despite this weighting today, you are paying about 1.7% more money to live. Corporations don’t typically pay this rate of inflation, but simply pass inflation costs over to the consumer.
When I read the December 2014 USA Today headline that the Russian Ruble had decreased 50% against the dollar from September to December 2014, I was shocked! Declining Russian oil prices are cited as the reason for the Rubles plunge in late 2014. Imagine that every dollar in your wallet or purse dropped in value to 50% in a few months. How would that make you feel? Are you willing to sit by and watch the value of your 401(k) plan drop in half to a 201(k) plan? Don’t you want to do something to protect your plummeting values?
The traditional investments that help battle inflation are real estate, equity investments and other hard assets such as commodities. With the price of gold dropping and commodities such as oil and natural gas dropping in value, having your money in an inflation hedge may appear to be attractive.
You may want to consider stocks or stock ETFs or stock mutual funds to hedge against inflation. Growth stocks are helpful to own in large company, midsized company and small company funds. Dave Ramsey says in his book, Total Money Makeover, to put your money into four types of stock investments equally; 1. Large Companies, 2. Medium-Sized companies, 3. Small Companies and 4. International companies. If you choose to use individual stocks, you may want to consider using at least seven stocks to decrease the impact of business risk in your portfolio. When searching for mutual funds, I recommend using Morningstar to analyze top mutual funds according to: style, performance, manager tenure, expenses, and upside/downside risk capture.
Another form of inflation hedging that I believe has proven to be good over time is real estate. You can invest into multi-family, residential, or commercial real estate to help you keep pace with inflation over time. Your rental income and property values can grow as your expenses increase. Finally, commodities, such as gold, have been a value preservation tool when the dollar devalues. Since the times of King Solomon, gold has been viewed as a stable source of value preservation.
When it comes to investments with bond-like returns, Welshire may recommend utilizing Fixed Indexed Annuities (FIAs) which can participate in some of the upside of the stock market without the downside risk. FIAs may be invested in different indexes, such as the S&P 500, a Value Stock Index, or the Nobel Prize winning Schiller Index, to name a few. Beware of the difference between cap rates and spread rates that can erode your index returns.
Cap rates are set with a maximum upside potential of the market such as 3% or 4%. No matter what the index does in a given year, you are limited to the 3% or 4% cap rate. For example, if stocks increased 20% in one year and your cap rate was 4%, you would only be credited 4% and would not earn the 20% maximum growth potential.
Spread rates are a fee charged by the insurance company, much like a mutual fund charges management fees, or a fee-only wealth advisor charges an asset-based fee. For example, if your spread rate is 2%, then if the market index you had grew by 20% in one year, you would net an 18% gain. In my opinion, the spread rate is superior to the cap rate. The beauty of either the cap rate or the spread rate is that when the index goes down, you earn zero. Zero becomes your hero since your friends’ stock investments may go down in value while your FIA might break even for the year.
You must also be careful of the surrender charges and market value adjustments (MVAs) in your FIA. Both the surrender charges and MVAs can cost you substantially if you pull out your principle in the first ten or so years. Much like selling an individual long-term corporate bond before it matures, you may experience a loss. If you chose to sell your FIA early, you may have to take a discount MVA or pay a surrender penalty.
Keeping pace with inflation is something your retirement wealth advisor should keep in mind for you. Please diversify your investments and understand that all investments contain risk, including the loss of principal. Past performance is not a guarantee of future growth. Contact your retirement wealth advisor for more information.