Protecting Your Investments from Inflation

By John Spitzer, Ph.D. and Todd Houge, Ph.D., CFA

For the long-term investor, even a modest level of unanticipated inflation can be devastating.  To illustrate the magnitude of the problem, consider an investor in the 32% tax bracket (combined Federal and State) who invests $10,000 for 10 years.  The security guarantees a 5% annual yield.  In 10 years, the investment will be worth $16,289 [$10,000 x (1+.05)10].  But if inflation is 3%, the investment will only be worth $12,121 in today’s dollars [$16,289 / (1+.03)10]  And, if the gains are subject to tax each year, the investor will only have $10,395 in today’s dollars [$10,000 x (1+.034)10 / (1+.03)10].  This amount is only $395 more than the original investment, representing an annual return of less than 0.4%!

As the illustration shows, there are two components to this problem – the first is the choice of assets, and the second is the matter of taxes.

Let’s start with the choice of assets.  While fixed rate securities do not adjust to inflation, there are some assets that adjust rather well.

We have two assets that adjust directly to changes in the CPI (consumer price index).  Both Social Security benefits and TIPS (Treasury Inflation Protected Securities) are adjusted each year to changes in the CPI.  As a result, both of these instruments offer complete protection against inflation, as measured by the CPI.

Historically, stocks have also provided very good protection against inflation.  But be careful – stocks have only provided this protection over the long run – in the short run, stocks have typically been pummeled by inflation.  This aspect is especially important for retirees – unless you have a long-term investment horizon, investing in stocks will leave you quite vulnerable.

Income-generating real estate can also provide protection against inflation.  Some leases are structured to include an automatic increase in the rent, with the increase tied directly to the change in the CPI.

Finally, money market yields have typically correlated well with the rate of inflation.  But money market yields have historically been almost identical to the inflation rate, thus providing very little return in real terms.  Moreover, with the Federal Reserve holding short-term interest rates close to zero, money market yields have recently been below the rate of inflation.

Now let’s turn to the second aspect of the problem – taxes.  The difficulty is that the taxing authorities tax your entire return, including the part that is due to inflation.  So, unless you have some protection, an asset that adjusts perfectly to inflation before taxes will fall short after you’ve paid the taxes.

To illustrate, suppose I invest $100 in a one-year security that promises to return my $100 adjusted for inflation.  If inflation is zero, the security pays me $100.  If inflation is 50%, the security pays me $150.   Absent taxes, I’m OK in both scenarios – I will receive enough to buy $100 worth of goods in today’s dollars.  But suppose I have to pay taxes on the income from the security.  I will be OK in the first scenario (no income, no tax).  But I will not be OK in the scenario with 50% inflation – I will have to pay taxes on the $50 income, so I will not have the $150 I need to maintain my purchasing power.

There has been some confusion, even among the financial gurus, about whether tax shields can provide significant protection against these effects.  For example, in the 3rd edition of Stocks for the Long Run, Jeremy Siegel wrote: “even for very long-term investors, inflation cuts into real returns [of stocks, because of the tax effect]. And the tax effect is more serious if stocks have been sheltered in a tax-deferred account.”

Fortunately, this is not the case – some tax shields provide excellent protection.  At the top of our list are the Roth accounts – Roth IRAs, Roth 401k accounts, and Roth 403b accounts.  With these accounts you contribute after-tax dollars.  Then, if you follow the rules, all of the withdrawals from these accounts are tax-free.  So these accounts offer complete protection against the tax effects relating to inflation.  (We add this feature to the list of other reasons why we really like Roth accounts.)

Just below the Roth accounts are the Traditional IRAs, Traditional 401k accounts, and Traditional 403b accounts.  With the Traditional accounts, you contribute before-tax dollars, and then all of the withdrawals are taxable.  Although it’s somewhat counter-intuitive, it turns out that if tax rates remain the same (and everything else is the same), the Traditional accounts give the same tax shield as the Roth accounts.  So if tax rates stay the same, the Traditional accounts also provide complete protection.

Tax-deferred annuities, where you invest after-tax dollars but then pay taxes on the earnings at withdrawal, do not offer much protection against these tax effects.  Suppose our investor above put the $10,000 in a TDA.  No taxes are due until withdrawal, but then the entire $6,289 of earnings is taxable, including the $4,168 that was due to inflation.

As a result, the investor in a TDA would have $14,276 after paying the taxes [$16,289 – 0.32 x $6,289].  Then, after adjusting for inflation, the investor would only have $10,623 in today’s dollars [$14,276 / (1.03)10].  This $623 return represents a 0.6% annual return – not much better than the 0.4% annual return posted by the investor without any tax shielding protection.  (We would also note that most TDAs have significant fees and have the noticeable disadvantage of taxing capital gains at ordinary rates.  For a more complete discussion of TDAs and their disadvantages, see the Tax Shields module of our website.)

Over the last 97 years, inflation in the United States has averaged 3.4%, but we have also experienced periods of considerably higher inflation.  Older investors will likely recall the inflation spikes of the 1970s and early 1980s, when consumer prices increased by as much as 14.7% in one year.  In fact, the annualized rate of inflation for the 1973–1982 decade was 8.7%.  We have also seen a sharp rise in food and energy prices over the last year.  While this unexpected inflation has caused many investors to reevaluate their asset mix, we also believe that it is important to carefully consider your choice of tax shield.