By Daniel J. Loewy and Christopher Nikolic
We've had a remarkable 30-year run of declining interest rates and modest inflation. As a result, few target-date glide paths were constructed with any inflation protection. We think it's time to act.
The last time US inflation surged was during the 1970s and 1980s (Display 1) -- long before the first target-date funds were introduced. During that last inflation spike, many investors fled bonds. They wanted to avoid being tied to fixed-income payments when interest rates were rising and inflation was eating away their spending power.
But they also demanded a bigger discount rate on equities, so both asset classes declined. This produced an extended period of negative returns for a traditional 60% stock/40% bond portfolio. And it highlighted that when inflation rises, the benefits of traditional diversification can break down, exposing target-date fund investors to potential larger-than-expected downside risks.
The Destructive Nature of Inflation
That's why inflation breakouts have historically been among the most destructive influences on a traditional stock/bond portfolio's returns. In Display 1, the green bars show the annual percentage change in the Consumer Price Index (CPI) -- a general inflation gauge. The purple bars indicate periods when the rolling 10-year annualized return for a traditional stock/bond portfolio was negative in real (inflation-adjusted) terms. Those periods happened only when inflation was rising, making inflation a crucial risk that any glide path design should consider.
Inflation risk becomes acutely important for participants near or in retirement. That's when portfolios really need tools to offset the potential decline in a traditional portfolio's value just as spending needs rise due to an inflationary environment.
Several asset classes shine when inflation is rising, but not traditional stocks and bonds. Treasury Inflation-Protected Securities (OTC:TIPS) will absorb the upward movement of inflation, and they're very important in protecting a bond portfolio against inflation. But they don't actually provide any further upside to guard against poor stock performance during inflationary periods.
The Benefit of Real Assets
However, various real assets -- such as real-estate investment trusts (REITs), commodity stocks and commodity futures -- respond quite positively when inflation is rising, or even when expectations for future inflation rise. Also, given their higher inflation beta (how much performance tends to move for every 1% change in the CPI), they can offer inflation-risk protection to the growth portion of the portfolio (Display 2, left).
We can think of these asset classes as a form of insurance. It pays off when inflation and/or inflation expectations rise, because these assets either cause the inflation (like certain commodities) or they're quickly able to pass through rises in inflation by hiking rent prices (like real estate).
Exposure to inflation-sensitive assets sounds sensible to many people. This allows inflation protection to be priced at a premium to traditional stocks and bonds. For example, if we compare the risks and returns of REITs, commodity stocks, commodity futures and TIPS to the stock/bond efficient frontier, they each fall below it -- some quite far below (Display 2). So, investors have to sacrifice some return or take on more volatility to get the inflation protection that any one of these asset classes provides on its own.
But we can reduce that return sacrifice by blending various real assets together. Commodity stocks, commodities futures and real estate have low correlations to one another, and they respond differently depending on the inflationary regime. This makes them well suited to diversify each other. When we combine them, we can deliver a significant "inflation beta" while still maintaining an efficient risk-adjusted return.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
"Target date" in a fund's name refers to the approximate year when a plan participant expects to retire and begin withdrawing from his or her account. Target-date funds gradually adjust their asset allocation, lowering risk as a participant nears retirement. Investments in target-date funds are not guaranteed against loss of principal at any time, and account values can be more or less than the original amount invested-including at the time of the fund's target date. Also, investing in target-date funds does not guarantee sufficient income in retirement.