Steering Through Inflation: Why Playing It Safe Can Be the Riskiest Investment Move

Terry Gerton Inflation is one of those financial topics that seems to be in the news almost every single day. We hear about it from the Federal Reserve, Congress discusses it in the context of affordability, and it even plays a role in the president’s approval ratings. But when we talk about inflation from your perspective, what does it truly mean beyond the simple definition?

Art Stein Well, inflation, you know, the basic definition is simply the rise in the cost of goods and services across the United States. That directly impacts our cost of living, which is a related but slightly different concept. When inflation rises, for most people, their cost of living rises along with it. If your wages or salary are increasing at the same rate, or even faster, then it might not be a concern for you. But if they’re not, then you’ve got a real problem. And the specific issue for FERS retirees is that their annuity, their pension, their annuity doesn’t fully keep up with inflation whenever inflation exceeds 2%. Over the course of a long retirement, that gap can be devastating. It forces many FERS retirees to pull increasing amounts of money from their investments, mainly their TSP for most retirees, and that kind of withdrawal pattern may not be sustainable over time.

Terry Gerton So let’s break that down into real-world terms because I think a lot of times people experience inflation as a feeling. It’s a sense that things are costing more. Your money just doesn’t stretch as far as it used to. But when you’re relying on an annuity as your main source of income, and you mentioned FERS is indexed at 2%, inflation has been running well above that. How does that actually affect people’s daily lives? What kinds of decisions are they being forced to make?

Art Stein Well, the decisions they’re forced to make, and let me clarify one thing first, the cost-of-living adjustment for FERS isn’t locked in at 2%. If inflation runs above 3%, the adjustment equals the inflation rate minus 1%. And if it falls between 2% and 3%, then it’s fixed at 2%, as you noted. The problem is we’ve been seeing inflation above 3%. This year, for example, inflation hit 3.8% in April and 3.3% in February. So FERS retirees are getting that minus 1% adjustment. As a result, people end up having to make tough choices. One option is to withdraw more from their various investments, including savings accounts. The other option is simply to cut back on spending, to buy less, to do fewer things, to choose cheaper groceries. Hopefully it doesn’t reach the point where people are buying less food, but they may have to switch to less expensive options. We’ve seen a massive spike in beef prices for a number of reasons, so people are cutting back on beef. Gasoline prices have also surged, and presumably people are driving less, although in the United States, driving is pretty deeply ingrained in people’s routines. So some will cut back, but many just keep on driving regardless.

Terry Gerton So for those who are depending on their FERS retirement as their primary income source, what should they be considering? Are there different investment allocation strategies that could help reduce the impact of inflation on their available funds?

Art Stein Yeah, so with the TSP, a common mistake people make is putting their long-term investments entirely into the G Fund, or having the bulk of their money there, and even the L Funds fall into the same trap. They start out heavily weighted in stocks, but beginning about 10 years before their target date, they shift too heavily into bonds. The L Income Fund, for instance, has roughly 67% of its holdings in the G Fund plus another 5 or 6 percent in the F Fund. The issue with those funds is that once you factor in taxes and inflation, they actually lose purchasing power. It’s very misleading because if you have money in the G Fund, every year you see that balance creep up a little, assuming you’re not adding or withdrawing funds. And you think, great, it’s growing in value, but it’s not. The purchasing power is actually declining. The dollar amount is going up, and those are two very different things. So if people have a large portion of their savings in those funds, they’re in for an unpleasant surprise 10 or 20 years down the road when they suddenly realize they have to withdraw more and more from the G and F Funds just to maintain their standard of living.

Terry Gerton Art Stein is a certified financial planner with Arthur Stein Financial. Art, what’s a better approach then? Should people diversify into a broader range of asset classes?

Art Stein Okay, let me also point out two other very common mistakes that people need to be aware of. The first is paying off their mortgage ahead of schedule. The problem is that home equity and early mortgage payoff simply increase the equity you have in your home. That equity earns a 0% rate of return. If your home’s price stays flat, the value of that equity stays flat. Now, if the home’s price appreciates, the equity will grow, but that’s a return on the house itself. The equity isn’t generating interest, dividends, or capital gains on its own, and it’s difficult to access that equity since it’s essentially locked up in the property. The second mistake is keeping too much money in bank accounts, because once again, bank accounts lose value to taxes and inflation. What people need to understand is that historically, only stocks have delivered a high enough rate of return within a well-managed, diversified portfolio to actually grow purchasing power after accounting for taxes and inflation. And that means the C, S, and I Funds. I think the TSP actually recognizes this because the L Funds start out heavily invested in stocks, roughly 99% equities for the first 10 years, and they don’t even drop to 60% until about 10 years before maturity. But then they over-allocate to bonds when they transition to the L Income Fund. So my advice is: first, make sure you maintain a solid allocation in stocks. If you’re facing a long retirement, don’t rush to pay off your mortgage, invest that money instead. Everyone can open an outside investment account. Make sure you have a solid emergency fund, so maybe direct some money there. And avoid keeping too much in bank accounts, because all of those choices work against you when you account for inflation and taxes.

Terry Gerton Art, it almost sounds like you’re flipping conventional investment wisdom on its head, and I’ll use my air quotes here, because people have always been told that stocks are risky, that you should definitely pay off your mortgage to eliminate that risk. How should people think about balancing risk and return during their retirement years?

Art Stein Terry, the reality is that there are many types of investment risk. One of them is volatility, and bonds are far less volatile than stocks, no question about it. Bank accounts essentially have no volatility at all. But another type of investment risk, and the most significant one for long-term investors, is the erosion of purchasing power due to taxes and inflation. So people shouldn’t say bonds are safer. They should say bonds are less volatile. They are safer in that narrow sense, but they carry more risk when it comes to losing purchasing power to taxes and inflation. Stocks are more volatile, but historically they have delivered a much higher rate of return for investors who are patient and willing to endure major stock market downturns, which, let’s be honest, are inevitable. We haven’t had a serious stock market crash in a while, and there’s definitely one coming in our future. I know it’s going to happen, and when it does, we just need to stay patient and hold on. Historically, that strategy has paid out for investors. Now, past performance is no guarantee of future results. There are certainly reasons to believe that stock returns going forward may not match what we’ve seen in the past. I don’t know what’s going to happen, and I won’t argue with the logic behind that view. But I haven’t heard anyone make the case that stock returns will underperform bond returns over extended periods.