Thursday, September 24, 2009

Inflation Protection

The Federal Reserve just told us that inflation isn't a worry. But let's remember that this is the agency that solemnly told us the mortgage crisis was manageable, even though one of its own members warned of problems. The Fed also didn't see the credit crunch coming, even though it's the top bank regulator. Then the Fed had to wing it with massive amounts of printed money in order to prevent the financial system from collapsing. Perhaps, in spite of official reassurances, one might wonder if those truckloads of printed money will have an unexpected inflationary effect. If you want a little inflation protection just in case, here are a few suggestions.

U.S. Treasury TIPS. TIPS are inflation adjusted U.S. Treasury bonds. They pay interest and also provide an inflation adjustment. You're taxed on the inflation adjustment as well as the interest, so your true inflation protection is reduced by taxes. And you have to pay taxes on the inflation adjustment on an ongoing basis even though you don't actually receive the amount of the adjustment until the bond matures (which could be years in the future). So you may have a cash flow issue. Nevertheless, there's no credit risk and that means something in these days when credit is still crunched.

U.S. I Savings Bonds. You can buy I Savings Bonds, which are inflation adjust savings bonds. Unlike TIPS, you don't have to pay any income tax on I Savings Bonds until the bond is redeemed or matures. Unfortunately, you can't buy more than $5,000 of I Savings Bonds a year. If you want to invest more in a U.S. Treasury obligation, you'd have to buy TIPS.

Inflation Adjusted Annuity. Some insurance companies offer annuities that provide for increased payments to compensate for insurance. These annuities aren't cheap--they often start paying at levels significantly lower than the amount of a fixed annuity you could buy for the same amount of capital. But there's a certain level of comfort in knowing that you'll get an increased monthly payment if inflation flares. Remember that annuities are subject to the creditworthiness of the insurance company. Also read the fine print for any limitations on the extent of the inflation protection. For more, see

Social Security Benefits. Social Security is actually a government sponsored annuity that adjusts for inflation. Although you can't get retirement benefits before age 62, Social Security is one of the best "investments" Americans can make. Do your best to maximize your benefits by working as long as possible. See

Some Pensions. Some pensions adjust for inflation, at least to a limited degree. If you have pension rights, make sure you understand how your pension works and build up your credits to maximize benefits. See

Stocks? Over long periods of time, stocks keep pace with inflation and even sometimes exceed inflation. But we're talking 25, 30 or more years. During the inflationary 1970s, stock investors lost their shirts to the depreciating dollar. If you bought stocks in the early 1970s, you didn't recover your losses on an inflation adjusted basis until the early 1990s (not a typo, not kidding). If you're 25 and saving for a retirement 40 years from now, stocks are a good idea for much of your portfolio. But if you're 70, don't view stocks as inflation protection. It might be worthwhile to have a modest portion of your money invested in stocks, just to catch any market upswings. But for inflation protection over the next 10 or 15 years, think about TIPS and I Savings Bonds, or maybe an inflation adjusted annuity from a very highly rated insurance company.

None of the above offer complete protection against inflation. But they're worth keeping in mind if you're not entirely sure you can rely on official assurances that all is quiet on the inflation front. Think about diversifying your inflation protection. Put some money in I Savings Bonds and TIPS, and possibly in an annuity or stocks. And keep working as long as possible.

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