Question: I am concerned about inflation. Despite government reports about low inflation, I seem to be spending more while not buying more. My water and electricity bills are higher. Most of my income comes from my retirement account, which is invested in a conservative portfolio of stock and bond mutual funds. I also have some money in CDs that are coming due soon. Is there any change I should consider to help me keep up with these higher prices?
Answer: The CPI - as reported by the Bureau of Labor Statistics - is 1.1% over the past 12 months. However, the Core CPI, which excludes food and energy prices, was up 2.3%. Falling energy prices explains the difference. So you might be paying less to fill up your tank, but you are spending more on everything else.
Stocks over the long run keep ahead of inflation. Bonds, not so much. If you buy a 5-year CD today yielding 2.3% with core inflation at 2.3% you are locked into losing real dollars when you include the tax you pay on the interest.
There are several options to choose from if you want to protect your fixed income portfolio from inflation during periods of rising interest rates:
1) Limit the duration of your bonds and CDs to less than one year. That way, when they mature you can reinvest the proceeds in higher yielding fixed income investments.
2) Keep your fixed income money in money market funds or very short-term bond mutual funds until yields are meaningful.
3) Consider moving some fixed income money into a fund that holds high dividend-yielding preferred stocks. Read up on them first to become aware of the risks. The iShares (PFF) and the Powershares (PGX) preferred stock funds are both yielding around 5.6%. Some of the dividends are taxed at lower capital gains rates.
4) Invest in I-Bonds. I-Bonds are inflation-protected U.S. Government savings bonds you can buy at TreasuryDirect.gov for any amount between $25 and $10,000, with a maximum purchase per social security number of $10,000 per year. They can be redeemed after the first twelve months, but are subject to a 3-month interest penalty if you redeem them during the first 5 years. You can defer federal income tax on I-Bonds until you redeem them, and they are free from state tax. The interest rate on I-Bonds consists of two parts – a fixed rate of return that stays the same for the life of the bond and a semiannual inflation rate based on the CPI-U (U.S. All Items Consumer Price Index). You cannot lose money in I-Bonds. They are U.S. Treasury securities, backed by the U.S. Government, and even if we have deflation instead of inflation, the value of your I-Bond will not go below its’ then current redemption value.
5) Invest in Treasury Inflation Protected Securities, or “TIPS”. You can buy 5, 10, and 30 year TIPS in $100 increments at TreasuryDirect.gov. At auction, the Treasury assigns a coupon rate. That’s the rate of interest the TIPS will pay semiannually until maturity. The Treasury adjusts the principal amount of the TIPS for changes in the level of inflation as measured by the CPI-U.
Kenneth B. Petersen CFP®, EA, MBA, AIFA® is an investment advisor and Principal of Monterey Private Wealth, Inc., a Wealth Management Firm in Monterey. He welcomes questions that you may have concerning investing, taxes, retirement, or estate planning. Send your questions to: Ken Petersen, 2340 Garden Road Suite 202, Monterey, CA93940 or email them to firstname.lastname@example.org.