These unconventional strategies may help inflation-besieged clients in the retirement zone

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High inflation has taken the U.S. by storm, with continually rising prices becoming a source of stress for almost everyone. But this environment is even more concerning for people in or close to retirement as inflation decreases the purchasing power of their hard-earned, but often limited, savings. After years of disciplined planning, the last thing retirees want is to fall short of their income needs because of inflation’s corrosive effects.

As people grow closer to that age, their retirement accounts often become more conservative, relying on bonds to offer income, stability and risk management. But the historical reliance on bonds to provide stability and inverse correlation to equities can no longer be expected. Recently, bonds have declined more than stocks and their real yield has been negative. 

Eben Burr

Furthermore, rising interest rates all but guarantee a bear market for bonds. The most recent such market lasted for 36 years and saw real losses of over 50% when one includes cost of ownership. In part, this is because the Federal Reserve’s primary tool to fight inflation is raising interest rates, which can cause principal losses and amplify real losses.

The past three instances of prolonged inflation, which we’re defining as periods where inflation increased by double digits within a year, led to average cumulative price increases of 101% and a 29% loss of purchasing power in bonds. Of additional concern is that high inflation globally has often been associated with high sovereign debt, much like the U.S. is experiencing now.

Equities are usually considered good hedges against inflation. However, according to a study conducted by my firm on inflationary periods, stocks are usually hit in the early phase of inflation, and only one of the three periods of inflation produced real gains. When factoring in these historical declines, equities only more or less matched inflation during times of high inflation and failed to produce meaningful positive real returns, on average. 

Both the stock and bond markets appear vulnerable to sustained losses then. Over the last three transitions from benign to high inflation, both stocks and bonds have correlated on the way down. Investors are confused about what to do with their money when the old-fashioned idea of allocating to a balanced portfolio exposes investors to these correlated losses. You need growth to keep up with inflation, but risk is everywhere.

Accepting the new reality
There’s unlikely to be any good news for markets unless the Fed backs off its plans to keep raising rates — which would actually just be different bad news of continued inflation. In the current climate, it’s imperative to start looking at client portfolios and asking hard questions such as:

●      Did I drift too far into the “buying the dip” comfort zone?
●      How vulnerable are my retired clients that are allocated to balanced strategies?
●      How do I reposition for a bond bear market?
●      Is it time to reconsider the hedged and tactical strategies that have mostly been out of favor since the great financial crisis of 2007-08?

The last question is especially important, as the evolving environment may require increased emphasis on protecting your investments. Investors should consider strategies that are best suited to handle risk in both stocks and bonds and think about how to select the best managers for these strategies.

Building portfolios with rising-rate and inflation contingencies
Thinking unconventionally may win the day in the current market. Instead of abandoning stocks and bonds altogether, making shifts to investments that attempt to address the contingencies of falling markets may allow investors to not only navigate high inflation, but potentially prosper.

First, shift stock allocations to hedge against market downturns. Investors need to maintain a stock allocation to fight inflation. But with high valuations and the potential for losses in the initial phase of rising rates, it’s important to employ hedging strategies for part of that allocation. A potential solution is to allocate 50% of stocks to hedged equity funds or high-conviction tactical strategies that attempt to de-correlate from falling markets. 

By hedging portfolios against market declines, investors can maintain their stock allocation but attempt to address high valuations and the reality that each period of high inflation over the past century saw stocks fall during the early years of increasing prices. 

Bond portfolios, especially for older or more conservative investors, should migrate to adaptive fixed-income strategies (such as tactical or unconstrained bond funds) that can tactically shift between short-duration, high-yield or investment-grade bonds, or TIPs. By migrating to these types of strategies, investors can maintain a balanced approach that may include a significant allocation of stocks, but potentially lessen exposure to market downturns. We use the term “behavioral portfolio” to describe an all-seasons approach to market conditions. 

There are several benefits to this structure. One is that it addresses the need for participation in equities that will move with the market so your clients feel a part of the market on the way up. Another is satisfying the natural desire to take action when markets are uncomfortable while potentially shielding from market declines with the risk-managed equities. And the last is taking advantage of shifting bond conditions to seek opportunity while seeking to avoid real losses.

Amid escalating inflation not seen in decades, people who are in or near retirement have every right to be concerned about the impact on their savings and purchasing power. With little certainty about the future path of inflation, it makes sense for older investors to be proactive, take a hard look at their portfolios and potentially implement hedging strategies that could help protect their investments.