PLANSPONSOR - October/November 2018 - 62

INVESTMENT FOCUS
Staying
Ahead of
Inflation
When current
assumptions may
not be enough
T
o a homeowner, the No. 1 enemy
is water: Even in small quantities,
invading rain, snow and ice
can degrade timber, crack concrete and
erode mortar. Similarly, a retiree's worst
adversary is rising prices. " Inflation is
the enemy of defined contribution [DC]
investors trying to protect their purchasing
power, " says Christine Loughlin, head
of the DC practice at NEPC in Boston.
A September 2015 thought exercise by
AQR Capital Management, in Greenwich,
Connecticut, estimated the purchasing
power losses that occurred during the
last big surge in U.S. inflation-between
January 1973 and December 1982-on
a hypothetical target-date fund (TDF)
portfolio invested 60% in equities and
40% in bonds. (See chart.) AQR writes:
" While the nominal hypothetical returns
of a traditional TDF seem attractive at a
total of about 101% over the period [from
$100,000 to about $208,000], the portfolio
actually experienced nearly 10% of
cumulative losses in real terms to about
$90,000 adjusted for inflation. "
" At any given time, the prices of equities
and bonds have inflation assumptions
built in, and the concern is that something
larger [will] come along, " says David
O'Meara, senior investment consultant at
Willis Towers Watson, in New York. " Right
now, the markets' assumption for inflation
is about 2% per year, which is not a big
risk. Even if it were to come along at 3%,
that's not a big deal for the markets.
" But if the low-inflation environment
of the last few decades turns into 8% or
10% for a long period, asset pricing would
be dramatically different, " he continues.
" We think that's unlikely, but it is a risk. "
Over periods of 10 years or more,
almost any financial asset can beat
inflation, O'Meara says. Many investors
view equities as an inflation hedge: As
prices rise, companies can charge their
customers higher prices and ultimately
restore profits. The full adjustment can
take years, however.
" But, over shorter periods, " he adds,
" especially for those who are drawing down
their assets, an inflation shock would
62 PLANSPONSOR.com October-November 2018 Art by Zohar Lazar
mean a smaller capital base to cover higher
expenditures. Therefore, participants in or
near retirement should have some exposure
to asset classes that react positively
to inflation. " He does not set a particular
target for returns during heightened inflation,
" but retirees would certainly want to
meet the rate of inflation, plus 1% or 2%
as a reasonable risk level in the portfolio. "
Fortunately, the investment ecosystem
offers a number of ways to protect retirees.
" Several food groups of assets respond to
inflation with better returns, " says Dan
Oldroyd, head of target date strategies at J.P.
Morgan Asset Management, in New York.
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PLANSPONSOR - October/November 2018

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