PLANSPONSOR - October/November 2018 - 63

For a portion of their portfolios, " Retirees
want a balanced breakfast of assets that
respond to different types of inflation,
ranging from commodities, to TIPS [U.S.
Treasury inflation-protected securities], to
real estate, to inflation-sensitive equities in
natural resources or infrastructure. "
In Oldroyd's thinking, inflation can
be expected or unexpected, and fast or
slow. " But you can't predict inflation, "
he says. And each state of it suggests a
different sort of inflation protection.
TIPS are the inflation hedge most
prevalent in TDF portfolios. The value
of TIPS bonds is adjusted to inflation
movements by a formula, making them
the most direct hedge, Oldroyd says. " But
there are arguments against their being
perfect, " he says. " They're relatively new
in the market, and, because they're bonds,
their prices are still driven by movements
in interest rates. "
" Commodities have a lot of inflation
sensitivity, and you don't need
much to accomplish a lot of hedging, "
says O'Meara. He notes that commodity
prices are often driven more by changes
in supply and demand than by inflation,
creating volatility not directly related to
inflation.
Real estate is another hedging asset
class, as commercial leases are generally
indexed to inflation. " Real estate earns
returns comparable to the broad equity
market, so you can hold greater amounts
without sacrificing returns, and it offers
diversification absent of inflation, " he
says. Exposure to real estate comes via
shares in public real estate investment
trusts (REITs) or direct investment in
private real estate.
Last is shares in companies operating
in natural resources or infrastructure. On
paper, prices of the former benefit from
higher revenues and profits as the price
of oil or metals rises, while infrastructure
companies' finances will be tied to inflation
in the same way as real estate.
" There is no perfect hedge for inflation, "
says Jeremy Stempien, vice president
at QMA, an investment arm of Prudential
Inflation Year-Over-Year Percentage Change
Consumer Price Index: All Items for the U.S., growth in quarterly index
from prior year, seasonally adjusted
16%
14%
12%
10%
8%
6%
4%
2%
0%
-2%
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016
Source: St. Louis Federal Reserve FRED economic database
Financial in Newark, New Jersey. " You can
poke holes in the reasoning for all of them.
Diversifying into several assets increases
the probability of protecting against degradation
of purchasing power. "
Inflation-protective assets are well
represented in TDFs: Vanguard's retirement
income sleeve allocates 17% to
TIPS, while the T. Rowe Price Retirement
2010 vintage holds 16% in TIPS, plus 1%
in a diversified fund of inflation-sensitive
equities. Stempien advocates for
about one-third of retiree assets in inflation
hedges.
But, given that high inflation is a
distant memory even for older employees,
and that the recent returns in U.S. equities
are in the high teens vs. 2% or so from
TIPS, few investors voluntarily choose
them from plans' fund menus.
" An inflation-sensitive core option is
probably 10th on the list of priorities for
DC sponsors, " notes Loughlin of NEPC.
Nonetheless, she believes inflation
protection can be fashioned into
worthwhile investment options. " We can
do some great things with direct real
estate-rather than REITs-and TIPS,
combined in a white label fund. That is a
neat investment, with the same expected
volatility as TIPS but a much higher
expected return. "
Can investors be confident with
these protections? O'Meara concedes that,
because the current market structure has
not been tested by inflation, empirical
evidence on individual assets or combinations
is not terribly strong.
" It might take a 1970s-style episode
to broadly hurt the financial markets, but,
to provide a buffer for that shock, we still
think it's important for the portfolios of
older participants to include inflationsensitive
assets. " -John Keefe
KEY POINTS
* The low-inflation environment has meant inflation assumptions are built
into the prices of equities and bonds at approximately 2% per year, but
little thought has gone toward preparing for inflation of 8% or 10%.
* Few investors voluntarily choose inflation-protective assets from a plans'
fund menus, but these funds are generally well represented in TDFs.
* Most financial assets can beat inflation over a period of 10 years or
more, but for participants in or close to retirement there are several
asset-sensitive classes that can help preserve funds.
PLANSPONSOR.com October-November 2018 63
U.S. CPI averages:
1960 - 2018: 3.8%
2000 - 2018: 2.2%
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