Inflation Considerations in DC Plans

By Gordon Tewell, CFA, CPC, QKC and Troy Jensen, QKA, APA

As retirement plan participants begin nearing their retirement age, the risk-averse investor’s primary goal becomes capital preservation. That can mean exchanging return for risk mitigation, usually by reducing the allocation to stocks and adding to bonds.

However, there is a lot happening in the bond market right now, most notably inflation at a 40-year high, pushing real yields to record low levels. Surging inflation means a decrease in purchasing power, but also led to the first Fed rate hike since 2018.

In a rising rate environment, a broad market core fixed income manager will typically struggle, due to its increased exposure to interest rate risk. That risk, also known as duration, has ranged from 6.5 to 7 years for the Bloomberg Aggregate Bond Index in 2022. This means that a 1% increase in rates will result in a percentage decrease of 6.5 to 7 percent in the index.

Safety in a defined contribution retirement plan may found in a stable value product, due to a much shorter duration than the core bond market. Many maintain a duration of approximately 2.5 to 3.0. At its core, a stable value fund is a defensive fixed income portfolio, while the underlying holdings are insured to protect the investor against negative fixed income conditions.

In the current low interest, high inflation environment, investors need to combat inflation's eroding impact on portfolios while also generating income. The challenge for bond funds is that they own bonds that are worth less if all the new bonds coming out offer higher yields. That’s why the prices of bonds are down and their returns are diminishing. Corporates, Treasuries, mortgages, long term, short term, international – you name it, they are all red this year.

Inflation-Fighting Assets

Common anti-inflation assets include commodities and natural resources, real estate, and Treasury Inflation Protected Securities. All of these asset classes come with challenges when looking to implement them in defined contribution plans, particularly for the risk-averse bond investor looking for inflation protection, as described above.

Commodities includes grain, precious metals, electricity, oil, beef, orange juice, and natural gas, as well as foreign currencies and other financial instruments. Commodities and inflation have a unique relationship, where commodities are an indicator of inflation to come. As the price of a commodity rises, so does the price of the products that the commodity is used to produce.

That relationship also carries some volatility. Commodities are dependent on demand and supply factors, and a slight change in supply due to geopolitical tensions or conflicts can adversely affect prices.

Exposure to rising commodity prices, either as a hedge against inflation or for capital appreciation is a challenge for defined contribution plan investors. Access may come through direct investment or through commodity futures. Direct investment outside a defined contribution plan may work well for smaller investments in precious metals, but it quickly becomes impractical in most other types. A fund-based approach may be used by a defined contribution plan using commodity futures, but can carry significant volatility and can be negatively impacted by the cumbersome need to roll into new futures contracts as existing contracts near expiration.

Natural resource investing includes anything mined or collected in raw form. Natural resources may go through further processing – say, cutting a tree into 4x4s, 2x10s, 2x4s, and so on – or simply be cleaned up, packaged, and sold (a barrel of oil or a bottle of water). Natural resources can act as stores of value, especially during times of rising inflation or currency depreciation.

Access to natural resources can be through direct investing, as with commodities, but this approach is impractical for most investors, particularly defined contribution plans. Access for defined contribution plans may come through the natural resources equity sector, which includes extraction of metals, coal, metallic ore, sand, gravel, and oil shale. It may also include logging and drilling for oil and gas.

Unfortunately, when it comes to inflation fighting, natural resource funds don’t always behave the same way as the natural resource itself. The notion that the shares of a natural resource company behave differently from the underlying commodity may seem puzzling. Why wouldn’t the price of, say, copper, be the largest factor in the price movements of a copper producer?

There are fundamental differences between these two asset classes that cause their price levels to move independently. Most notably, company-specific factors will influence an organization’s stock price, but not the price of the underlying commodity. While stock prices will change to reflect company-specific changes in dividend policy, corporate governance, or earnings potential, there’s no reason to expect that this will have any impact on the associated commodity.

Other challenges for investing through equities include the regulatory environment for natural resource stocks and the tendency for equity prices to move together as an asset class. Many natural resource related companies are aware of their commodity exposure and may actively hedge away this risk using forward price agreements or other instruments. While this doesn’t completely immunize these companies from the price impacts of the underlying natural resource, it diminishes the relationship between a company’s profitability—and, indirectly, its share price—and the price of the underlying commodity.

This disconnect between natural resource prices and the performance of natural resource company stocks causes inefficient exposure when used in defined contribution plans through natural resource mutual funds.

Real estate investments – offices, apartment buildings, warehouses, retail centers, medical facilities, data centers, cell towers, infrastructure, and hotels, as a class – have traditionally had the characteristic of performing well in an inflationary environment. The assets have several benefits during periods of high inflation, including appreciation as property values keep pace with inflation, fewer real estate development projects due to rising labor, material, machinery, and other costs, and increasing rents.

Implementation into a defined contribution plan continues to be the challenge for this asset class. Like other inflation-fighting asset classes, direct access to real estate – owning actual properties – is the most effective and least volatile, but in the daily-traded, liquid environment of defined contribution plans, direct ownership is difficult.

Defined contributions plans may implement access to real estate through investment like Real Estate Investment Trust (REIT) funds. REITs are companies that own and operate income-producing real estate. However, there are drawbacks. As stocks of companies, not direct real estate, the performance of REITs tends to be much more volatile than direct real estate. REITs are also sensitive to rising interest rates.

REITs also have a high correlation to the broad stock market. From 1972 to 2018, REITs have had a slightly higher average total annual return than the US Total Stock Market (11.4% vs. 10.3%), but also a higher average standard deviation (16.9% vs. 15.5%).

Treasury inflation-protected securities (TIPS), a type of U.S. Treasury bond, are indexed to inflation to explicitly protect investors from it’s impact. TIPS adjust the amount investors receive based on changes in the consumer price index. Twice a year, TIPS pay out at a fixed rate. The principal value of TIPS changes based on the inflation rate, and so the rate of return includes the adjusted principal. This means that investors get paid more as inflation rises.

Despite the inflation protection, an overall rise in the level of interest rates will still feed through to the TIPS market, putting downward pressure on prices. In addition to the changing expectations for inflation, the Fed’s stepping back from the quantitative easing is removing a massive source of demand that had pushed yields down.

We have and are going through a period when the investment environment has changed, and expectations are that returns on multi asset portfolios are likely to be lower than they have been in the past.

Investors still actively in the workforce have greater choices. The first – and likely least attractive – is to simply save more. Investors can save more or delay retirement, which in effect will decrease the level of wealth required in retirement.

The second option is to focus on increasing exposure to growth-seeking assets, either through more equity or higher-returning segments of the fixed income market. This approach has the potential to boost long-term portfolio return potential by increasing the level of market risk within a portfolio either through adjusting the balance of assets between equity and fixed income or adjusting within asset classes.

A third option to address lower return expectations is to adjust spending in retirement. Research on retirees’ spending habits reveals that retirees tend to adjust their spending to their income.

Still, getting investments right is critical. Moving into a period of lower expectations for returns reduces the margin for error. Retirement plan investors may consider the following to increase their chances of success:

• Understanding that successful retirement outcomes necessitate a long-term investment perspective.

• Diversifying across both equities and fixed income to pursue excess returns.

• Focusing on investment options that have the potential to perform well in a variety of market environments.