Be Wary of Inflation and Deflation

Think inflation is just a small, irrelevant detail? Guess again.

One of the most important parts of retirement planning is figuring out how your assets should grow in “real terms” so that you can maintain your retirement lifestyle. “Real” growth is what’s left over after inflation.

Most existing financial planning models assume a certain base rate of annual inflation – 2% or 3% – and incorporate that assumption into the model from now until your retirement date. They also run some alternative “worst case” scenarios to see how robustly the models hold up under extreme conditions.

That’s all well and good, but the Great Recession of 2008 brought another bogeyman back into view, and that is deflation.

To be as well-prepared as possible, your retirement planning needs not only a Plan B – what happens if we have hyperinflation? – but also a Plan C, namely what do we do in a deflationary environment? Let’s look at each of these in turn.

Plan B: Extreme Inflation

We haven’t experienced an extreme inflationary environment in the U.S. since the early 1980s, when concerted efforts by then-Federal Reserve chairman Paul Volcker broke the back of a decade of spiraling prices coupled with stagnant growth. This was known as “stagflation.” Several factors were responsible: the wage-price indexation policies of the Nixon administration, ending the fixed conversion of the U.S. dollar into gold, and the OPEC oil embargo of the early 1970s were prominent among these.

What to do: In high-inflation environments, real assets tend to perform well. It’s generally a good idea to have a commodities allocation in your portfolio, because it acts as a diversification benefit in normal times. You can increase your weighting in times of sustained high inflation.

Unfortunately commodities tend to be highly volatile, so if you are increasing your commodities weight and need to decrease other asset exposures, those decreases should come from other higher-risk asset classes like equities. Bonds also tend to perform poorly in high inflation environments because inflation can produce negative real returns. Inflation-protected securities like TIPS offer protection against this.

Plan C: Deflation

High inflation is bad, but deflation is arguably worse. Consider Japan, which has seen a near-constant deflationary environment since the early 1990s. The Nikkei 225 stock index reached a peak of just below 40,000 at the end of 1989. Here we are 24 years later and even after a mostly strong performance in early 2013 the Nikkei is still below 15,000 – about 37% of its peak value. Clearly that’s a recipe for an unhappy retirement.

In a deflationary environment the basic laws of finance are turned on their head. There’s an incentive to hoard cash rather than invest it, because a dollar today will have more purchasing power in a year’s time if prices continually fall between now and then.

What to do: there aren’t many avenues to increased wealth under deflation, but assume that the most stable economic sectors will be things like consumer staples and utilities, as a result of households reducing their discretionary spending. People will give up a lot of things before they stop paying the electric bill or cut back on soap and toothpaste. These kinds of defensive sector equities can be relatively successful in a world of few choices.

Of course we all hope that we will get from here to retirement without either extreme inflation or deflation throwing up roadblocks. Neither scenario is a high-probability outcome, nor should either dominate your retirement planning. But it is always a good idea to be prepared.

Are you worried about inflation or deflation? Tell us what you think.