Inflation Protection for DC Investors

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency,” wrote economist John Maynard Keynes in 1920. “The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” Those may seem overblown and archaic words, especially in view of the low inflation prevailing in the U.S. for the past 20 years—above 3% annually just four times, and under 2% for eight years.

But a regime of higher inflation and more volatile price swings may be in store. On August 27, Jerome Powell, chairman of the Federal Reserve, declared that the central bank will adopt a new policy toward inflation—one that gives a higher priority to its job of maintaining employment. And rather than immediately counteracting any inflation that appears on the economic horizon, the Fed’s new policy states: “[F]ollowing periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”

While Powell has not promised higher inflation, he will allow it in order to sustain economic recovery. Accordingly, sponsors of defined contribution (DC) plans and their advisers should take a fresh look at the prospect of rising inflation and what effects it could have; identify which participants need the most protection; and assess the priority, and the cost, of protection for their plans’ investment offerings.

Looking Out For Near Retirees

The need for inflation protection is especially acute among those in or near retirement: those at the end of their earning years, unable to catch up to rising prices through salary increases and typically guided to more conservative, lower-return investment strategies. “What’s needed is protection from a sudden move from low to high inflation, which can ravage nominal stock and bond returns,” says Bransby Whitton, a product manager in the real asset group at investment manager PIMCO in Newport Beach, California. “Once you’re past that, every asset in a portfolio will have been repriced to that new level.”

“That’s not to say that younger participants wouldn’t benefit from inflation-sensitive assets, although their need is different,” Whitton observes. “It’s less about inflation and more for diversifying the returns of mainstream stocks and bonds. In the case of target-date funds [TDFs], we take seriously giving all participants a smoother ride.”

When inflation has been so low for so long, it is a challenge to identify those financial assets that will deliver the needed protection for purchasing power. The list of candidates is sizable: TIPS [Treasury inflation-protected securities], which adjust their principal value to increases in the consumer price index (CPI); commodities, rising prices of which can be the root cause of inflation; real estate, where rents and property values tend to rise with inflation, though over time; non-U.S. dollar currencies; and listed equities of natural resource and infrastructure providers, whose earnings can respond to rising prices quickly.

“Economic fundamentals tell us that a greater supply of money chasing limited resources, from all the recent monetary and fiscal stimulus, will push prices higher,” says Bobby Blue, an analyst in the multi-asset team at fund researcher Morningstar in Chicago. “But, without much inflation in the last 30 years, it has not been a driver of financial market returns.”

Even the longer historical record during the high-inflation 1970s and 1980s is not illuminating, he notes. “Direct commodities in a mutual fund format were not formalized until the 1990s, and other asset classes people point to such as direct real estate, REITs [real estate investment trusts] and infrastructure weren’t standardized until recently, either.” Accordingly, he concludes, “It’s hard to specify a specific asset class and know it will perform well against inflation.”

TDF Managers’ Inflation Strategies

With so much to choose from, and scanty evidence, TDF managers take varied approaches to inflation protection. “When we construct custom TDFs, all age cohorts have some allocation to inflation-sensitive assets. It’s modest earlier in the glide path and increases up to retirement,” says Felicia Bennett, managing director at Wilshire Associates in Pittsburgh. “That’s consistent with many off-the-shelf TDFs, where the 2055 vintage might have 1% in TIPS, real estate around 4.8%, and natural resource, energy and infrastructure equities of 4.4%. Then, in income funds for retirement, the median TIPS allocation jumps to 10%.”

Another avenue to inflation protection is a dedicated fund in the core menu. “We tend to recommend an allocation to a diversified public real assets fund, with a variety of asset classes,” says Bennett. “Funds that contain some equities and are oriented toward growth—so as to not have flat returns when the equity market is roaring—have more volatility. TIPS play an important role in dampening their volatility.”

Sponsor support for inflation-sensitive core options is not universal, however. “Fund objectives are hard to explain to participants, and some clients have declined to put them on the table because the names can be confusing and suggest that ‘real return’ means the results will always be positive,” Bennett says. She adds, though, that they can be useful nonetheless in a managed account setting, where the professionally managed service could deploy an inflation-sensitive option.

For its Inflation Response Multi-Asset Fund, managers at PIMCO prefer to invest closer to the source. “Versus the actual commodities, public equities of natural resource companies can offer diluted inflation protection,” notes Whitton. “There’s a positive inflation beta from the natural resource part, but a negative inflation beta from the equity component. So natural resource equities pack about 50% of the punch you can get from going directly to the commodities.”

In view of the force-feeding of the U.S. economy from the trillions in government support in the COVID-19 crisis, and potential for higher inflation, how are TDF managers revising their views on allocations to inflation-sensitive assets? At Vanguard, Senior Product Manager Brian Miller in Philadelphia notes that the firm does not make tactical adjustments to its TDF glide path, and the allocation to short-term TIPS for older participants is steady at 17%.

According to Whitton, the inflation fighting component of PIMCO’s TDFs is currently at 16% of portfolios, down from as high as 21% in the past five years, but, “as the risk of inflation has increased, we could raise that allocation going forward.”

Dan Oldroyd, head of target-date strategies at J.P. Morgan Asset Management in New York City, explains, “At this moment, we don’t have a strong view on inflation and have not altered our positioning as a result, but we’d want to maintain exposure to these assets in the event of any surprises. With that said, though, we are underweighting the real estate exposures in our glide path to reflect the near-to-intermediate impact of COVID-19 on some sectors of the real estate market. Therefore, the number is close to 15% at the moment.”

From his Morningstar bird’s-eye view, Blue points out that, while some managers dug in for inflation after the financial crisis but then accommodated rising prices less when the wave did not appear, “They’re saying this time may be different, in that money has been put directly into the hands of consumers and that change may ultimately increase prices. Inflation is now becoming top of mind.”

Art by Bill Mayer