Buffering 401(k) Plans From Inflation

Allison Bell

What should retirement plan sponsors do about the possibilitythat prices might rise (or fall) a lot?

Most experts say the best mainstream strategy that advisors canrecommend to employers is to offer a solid, diversified set ofmutual funds, along with options that guarantee return ofprincipal.

Some experts are talking about funds that invest in“inflation-linked” securities, such as Treasury Inflation ProtectedSecurities, and a few advisors say plan sponsors might consideroffering adventurous participants a little exposure to swings incommodity prices.

To many investment experts, the idea of talking about the returnof severe inflation to the U.S. economy seems odd. Most U.S.companies still have a hard time making price increases stick, andthe Consumer Price Index rose only 1.7% between February 2003 andFebruary 2004.

Daniel Shaffer, president of Shaffer Asset Management L.L.C.,White Plains, N.Y., is one of the investment advisors who stillworries about prices sinking.

Throughout the world, “we're seeing extreme pressure fordeflation, not inflation,” Shaffer says.

Shaffer, whose firm manages stock portfolios and commodityinvestments for profit-sharing plans as well as individuals, saysU.S. businesses' sluggish response to short-term interest rates ofjust 1% shows that the economy continues to suffer from the effectsof the 1990s stock bubble.

But others worry that inflation could be creeping back. FederalReserve officials have held short-term rates at 1%, and the CPIincreased at an annualized rate of 6% in February.

Another indicator, the U.S. Dollar Index, a measure thatcompares the value of the dollar with the value of a basket of 6other major currencies, shows that the value of the dollar hasdropped about 25% since February 2002.

Despite the global pressure for deflation, U.S. consumersprobably will see prices go up as businesses respond to the newweakness of the dollar, Shaffer predicts.

Even if the annual inflation rate simply increased to 4% andstayed there, that could throw off some employees' retirementinvestment strategy, advisors say.

If a 45-year-old employee contributes $1,000 to a 401(k) plantoday and generates an average annual return of 8% for 15 years,the $1,000 contribution should bring in about $2,170 in investmentearnings.

If 4% annual inflation cuts the real, inflation-adjusted returnin half, the $1,000 contribution will bring in investment earningswith only about $800 in current purchasing power.

In theory, an employer could help employees cope with inflationby adding a gold fund, a mining fund or an oil exploration fund toits 401(k) plan portfolio.

The problem is that narrowly focused commodity-based funds addmore volatility than most 401(k) plan participants can handle, saysLynn Russell, the mutual funds analyst at Morningstar Inc.,Chicago, who follows international bond funds and precious metalfunds.

“Folks have talked about commodity funds, but they bring a lotof risk to the table,” Russell says. Even young, sophisticated planmembers who can accept a high level of risk probably should limitcommodity-based investments to 5% of their plan assets, Russellsays.

Shaffer says sophisticated plan members may be able to put 10%of their plan assets in well-managed, highly diversified commodityfunds.

For now, though, the most popular strategy for inoculatingretirement plans against inflation may be investing in TreasuryInflation Protected Securities and funds that buy TIPs.

The U.S. Treasury began selling TIPS in 1997 to give consumersan easy way to protect their assets against inflation. Thegovernment adjusts the consumer's investment principal to reflectincreases in the urban CPI, then applies a fixed interest rate tothe adjusted principal. The current fixed rate on a 10-year TIPS isabout 2%.

Private companies are starting to come out with inflation-linkedinvestment products of their own.

John Hancock Financial Services Inc., Boston, recently beganselling inflation-linked, 10-year notes through the Web. Hancockcalculates the rate paid on the notes by adding a 1.5 percentagepoint spread to the urban CPI rate. The current rate on aninflation-linked Hancock note is 3.19%, and Hancock says it willadjust the rate every month.

Reproduced from National Underwriter Edition, April 19, 2004.Copyright 2004 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.