Are These Really the Best Way For Retirees to Stay Ahead of Inflation? by Scott Stolz, CFP, RICP (week 48)

 

I enjoy going to the grocery store.  To me, it’s like a treasure hunt.  Not only do I have a list of items I have to find, but you never know what else you will come across that you didn’t know you needed, but you must buy.  However, these trips aren’t as fun as they used to be.  Not only is the price of everything higher, but the packaging seems to keep getting smaller.  Since when was a half-gallon only fifty-two ounces?  And since we are trying to increase our longevity by purchasing organic when possible, the cost is even higher.   I used to get out of the grocery store for less than $100, but now I’m consistently pushing $200. 

 

So, you can imagine my interest in an article entitled “Strategies for Staying a Step Ahead of Inflation” in the May 10 Barron’s Retirement column.  Every retirement plan needs a moat to protect against inflation reducing your purchasing power, so I was curious to see what strategies Barron’s was recommending.  I found the suggested solutions to be pretty typical.  They included the following:

·       Stocks with higher-than-average dividends, especially utility stocks, because utility companies are granted regular rate increases to help cover any increasing costs.

·       U.S. Treasury bonds with maturities of 4-10 years because they have a high degree of safety and yields slightly greater than inflation (unless you buy a lot of beef).

·       Short-term investment grade bond funds for much the same reason as the previous recommendation.

·       Short-term tax-exempt bond funds because their after-tax yield exceeds inflation,

·       U.S. Treasury Series I Bonds because their interest rate is reset every 6 months based on inflation rates.

All of these solutions have one thing in common – they attempt to provide a return slightly higher than the current reported inflation rate of 3.8% with minimal downside risk.  In short, they are designed to keep inflation from making you go backwards, but they offer minimal, if any opportunity for returns beyond inflation.  What if your goal is to get a return greater than inflation without putting your principal at risk?  If that interests you, let me add two strategies to the above list – a principal protected structured note (PPN) and a fixed indexed annuity (FIA).

Essentially these two strategies are the same thing.  They both provide a guarantee that at maturity, you will get back no less than what you invested.  In addition, they pay a return equal to a percentage of a specific stock index in lieu of a specified annual return.  The biggest difference between the two is that PPN’s are issued by banks and FIAs are issued by insurance companies. 

Let’s look at an FIA example using Eagle Life’s Eagle Select Focus 7.  It currently offers an option that will provide a return in the first year equal to 100% of the change in price of the S&P 500 up to 9.5%.  Therefore, if one year after you buy this particular FIA, the price of the S&P (excluding dividends) is higher by 0-9.5%, you would be credited with that specific return.  For example, if the index was up 5%, you would get 5%.  If it was up 9.5%, you would get 9.5%.  If the index is up more than 9.5%, you would “only” get 9.5%, since you can’t earn more than the 9.5% cap.  If the index is down, you will earn 0% in that particular year no matter how much it is down.  The 9.5% cap on the upside is the price you pay for the 100% downside protection.  A PPN with the same pricing would work the same way.

This raises the question of what you should expect to earn on average given this pricing?  After all, the market will have a different return each year, therefore there will be years when you get between 0-9.5%, there will be years you will get 9.5% and there will be years when you get 0%.

At this point, I’m pretty much required to say that past performance is no guarantee of future returns.  However, it does give us some indication of what to expect.  Historically, the stock market has gone up in 3 out of every 4 one-year periods.  Therefore, a buyer of these products should expect to earn 0% one out of every four years (assuming they choose the one-year option rather than a multi-year option).  On the other end of the spectrum, the S&P 500 is up at least 9.5% almost 50% of the time.  Therefore, a buyer can expect to get credited up to the full cap about 1 out of every 2 years.  That leaves 1 in every 4 years where they will earn between 0-9.5%.  When you do the math on this range of possibilities using a tool offered by iCapital, you’ll find that the average annual historical return is about 6.5%.  That’s certainly much better than you can expect to earn from any of the solutions offered in the Barron’s article. 

A couple of things to consider before choosing either a PPN or FIA as a solution.  Both products are designed for you to own them for 3-7 years.  Cashing them out early can cost you much of the interest you would have earned.  If you are not willing to take a buy and hold approach with these products, then take a hard pass. Second, rate terms are subject to change by the issuer.  In other words, while you might get a 9.5% cap in year one, you might get more or less (typically less) in year two.  Therefore, before buying, you should ask for a history of the issuer’s renewal rates.

Personally, I find these two strategies superior to the ones listed by Barron’s.  If I can earn on average 6%+ with 100% downside protection, I can not only keep up with inflation but actually increase my purchasing power over time.