Buffering 401(k) Plans From Inflation

Allison Bell

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

Most experts say the best mainstream strategy that advisors can recommend to employers is to offer a solid, diversified set of mutual funds, along with options that guarantee return of principal.

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

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

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

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

Shaffer, whose firm manages stock portfolios and commodity investments for profit-sharing plans as well as individuals, says U.S. businesses' sluggish response to short-term interest rates of just 1% shows that the economy continues to suffer from the effects of the 1990s stock bubble.

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

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

Despite the global pressure for deflation, U.S. consumers probably will see prices go up as businesses respond to the new weakness of the dollar, Shaffer predicts.

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

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

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

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

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

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

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

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

The U.S. Treasury began selling TIPS in 1997 to give consumers an easy way to protect their assets against inflation. The government adjusts the consumer's investment principal to reflect increases in the urban CPI, then applies a fixed interest rate to the adjusted principal. The current fixed rate on a 10-year TIPS is about 2%.

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

John Hancock Financial Services Inc., Boston, recently began selling inflation-linked, 10-year notes through the Web. Hancock calculates the rate paid on the notes by adding a 1.5 percentage point spread to the urban CPI rate. The current rate on an inflation-linked Hancock note is 3.19%, and Hancock says it will adjust the rate every month.

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

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Buffering 401(k) Plans From Inflation

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