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Managing Inflation Within Target Date Strategies

Inflation is a significant, though often overlooked risk, that can devastate retirees’ purchasing power. Building a plan today helps to buffer from unpredictability tomorrow.

Investment Strategist
Senior Portfolio Manager

Target retirement strategies continue to grow as a leading default vehicle, offering professionally managed, age-appropriate portfolios that automatically rebalance in order to keep participants on target. However, there are key differences between providers in how each strategy manages key investment risks as they evolve in importance for participants at each stage of their careers. As inflationary pressures have arisen over the last 12-18 months, causing traditional stocks and bonds to underperform in tandem, strategies lacking in inflation protection have struggled. Most notably, participants approaching and entering retirement have been exposed to meaningfully negative returns from nominal bonds, which make up the majority of retirement portfolios in many Target Retirement strategies.

A well-designed target retirement strategy needs to do more than just account for market volatility; it should also seek to preserve investor purchasing power from the corrosive impact of inflation. Thoughtfully balancing these key investment risks by delivering efficient portfolios while being mindful of potential negative shocks is crucial in seeking to deliver successful retirement outcomes.

A Recent History of Inflation

Until recently, inflation had largely been an afterthought for the vast majority of today’s DC participants throughout their careers. A longer view of American history illuminates the severity of this risk. For example, the average investor would have been worse off retiring in 1966 at the beginning of the Great Inflation than at any other time in American history — including the Great Depression. Driven in part by policies aimed to promote economic stability, inflation skyrocketed from above 1% per year in the early 1960s to higher than 14% in 1980.1  Retirees drawing down on their savings while investing in a diversified mix of stocks and nominal bonds would have lost more than 70% of their purchasing power during this period, severely compromising their ability to spend in retirement.2  The Great Inflation offers a cautionary tale about the impact unexpected inflation can have on portfolios, underscoring the importance of structurally addressing this risk for the subset of participants most vulnerable to its effects.

Today’s Inflationary Environment

While the world is very different today, inflation is once again dominating the headlines with the far-reaching impact of soaring shelter, food and gas costs disrupting every-day life for retirement savers. June’s CPI print reflected an 8.6% year over year increase in inflation. While consensus has emerged that inflation may be nearing a peak, both one and three year forward looking inflation uncertainty as measured by the New York Fed’s Survey of Consumer Expectations remain elevated, suggesting that even as inflation subsides it will be some time before we are back in line with the Fed’s long-term 2% target.

While inflation-sensitive asset classes have had a strong run of outperformance as realized inflation has increased, inflation is a key structural risk that should be addressed on an ongoing basis, and exposure to inflation protection remains an important consideration for investors; both for the diversification benefits and the potential for continued outperformance during inflationary periods.

Figure 1: Inflation Uncertainty

Higher inflation has already had an adverse effect on asset returns across traditional equities and nominal bonds in 2022, in addition to the stress it adds to participant withdrawal rates to account for higher cost of living. Given the risk that inflation poses to investors, we believe that an important strategic objective of the glidepath should be to mitigate the potentially negative impact rising inflation has on a portfolio. In seeking to carry out this objective, two questions need to be answered in order to build an effective inflation-sensitive allocation: (1) When is it most appropriate to include an inflation-hedging allocation, and (2) what is the appropriate mix of asset classes to hedge inflation?

Applying Inflation Hedging: Time Horizons

First, where would this allocation be most appropriate in order to improve outcomes? For younger investors that have 20, 30 or even 40 years until they’ll begin to use their savings to fund their retirement spending, current inflation – absent any impact on savings rates -- is less of a concern for long-term investment outcomes. In fact, a hypothetical portfolio of 90% stocks and 10% bonds has outperformed inflation 100% of the time when looking at rolling 20 year annual periods since 1929.3

However, for older investors that are about to or have already begun to spend down their retirement savings, current inflation poses a much greater investment risk. Older investors have a shorter time horizon for their investment objectives and have few or no working years to offset the impact of inflation through wage growth. Retirees, in particular, need their portfolio to prepare for a range of market environments, from rosy economic growth to recession or, of course, rising inflation.

Further complicating matters, more conservative portfolios have a much more mixed history of outpacing inflation over shorter time horizons. Inflation has outpaced a diversified mix of 35% stocks and 65% bonds almost one out of three years since 1929, and one out of five years even when looking at a rolling 5-year window. Not only do they occur more than we think, but these inflationary periods can pack a punch.

In aggregate, looking back over nearly 50 years, we can observe that stocks and nominal bonds have delivered negative real returns in periods of rising inflation. For those retirees seeking to use their accumulated wealth to purchase goods and services in retirement, the potential for negative real returns from traditional asset classes can be especially corrosive. For those older participants, a meaningful allocation to inflation-sensitive asset classes takes on outsized importance.

Figure 2: Real Assets Have Outperformed in Periods of Rising Inflation

Applying Inflation Hedging: Asset Allocation

Second, what is the appropriate mix of asset classes to address this? An allocation to real assets can provide inflation-hedging potential, diversification to traditional stocks and nominal bonds, and a source of returns. Treasury inflation-protection securities (TIPS) are an obvious place to begin, but an inflation-protection strategy that focuses solely on TIPS won’t accomplish our objective in the most efficient manner or enable us to maximize growth.

In a rising inflationary environment, TIPS will provide inflation protection and perform better than their nominal bond equivalents, but they will likely generate returns that are less than desired as an inflation hedge. Because TIPS are indexed to inflation, their principal adjustments are backward-looking by nature, and as such they tend not to perfectly hedge unexpected inflation. Shifting exposure to a shorter-duration TIPS index can potentially mitigate interest rate volatility and better align with future inflation expectations as shorter duration bonds tend to have a stronger, more positive relationship with inflation. The State Street Target Retirement strategies feature an 18% allocation to Intermediate TIPS in retirement.

Rather than limit our approach to this one core exposure, our strategy instead seeks to create a more efficient inflation protection basket by complementing an allocation to TIPS with additional asset classes such as commodities and real estate investment trusts (REITs). This approach can offer inflation-management benefits at different points within the economic cycle, along with potentially higher long-term return expectations (see Figure 3). Historically, commodities have performed best during periods of rising inflation or unexpected inflation. They have exhibited a strong beta and correlation to inflation, due to their ability to reprice quickly based on economic conditions and shifts in supply-and-demand dynamics. Thus, a small allocation to commodities can be used advantageously to help protect purchasing power and provide portfolios with insulation from unexpected inflation. REITs have demonstrated the ability to perform well across all three inflationary regimes, particularly during periods of stable and rising inflation, due to pass-through effects where REITs can adjust rents and pass along price increases to tenants. In aggregate, this inflation-hedging strategy allows State Street to meaningfully address inflation risk within the context of the other key risks that participants are facing — accumulation, volatility, and longevity — rather than viewing the problem in isolation.

Figure 3: Asset Class Inflation Beta Correlation to Inflation

September 30, 2002 to March 31, 2022

Figure 4: A Greater Focus on Inflation Management

State Street Provides a Meaningful and Diversified Allocation to Inflation Managing Asset Classes

Inflation, like volatility, can emerge at any time. Within your plan default, look for Target Retirement strategies that place a meaningful emphasis on inflation protection when it matters most to retirement savers. State Street Global Advisors utilizes 11 underlying asset classes to build our glidepath, using a granular set of exposures that expands beyond traditional stocks and bonds to provide exposure to Real Assets such as Commodities, REITs and TIPS. Such exposures deliver higher expected returns in periods of rising or unexpected inflation, better protecting retirees against the erosion of purchasing power. This has been particularly notable over the last year as inflationary pressures have risen – as the State State Street Target Retirement Income Fund has outperformed 96% of peers.

Over the long-term, our approach to balancing key risks has resulted in a consistent level of peer-relative performance in our retirement vintage over time. The idea is to not significantly outperform in any one market environment while exposing investors to expected underperformance in others, but rather to provide a well-diversified mix of investments that can address the key risks that participants face. As testament, the State Street Target Retirement Income fund has outperformed 82% of its peers since its inception in 20054, delivering a consistent history of strong peer-relative performance across a range of market environments.

Considering the Core

Inflation-hedging options have become increasingly prevalent on core menus, allowing do-it-yourself participants to address this key risk through asset classes beyond traditional stocks and bonds. However, investing in inflation-sensitive asset classes on a standalone basis exposes investors to a number of potential issues that may be mitigated through a multi-asset solution. Many plans today offer TIPS funds as a potential inflation hedge, which exposes investors to varying levels of interest-rate risk and may not provide the desired level of sensitivity to unexpected inflation. Further, asset classes like commodities and REITs, which often improve portfolio efficiency in a multi-asset framework, feature considerable volatility on a standalone basis. A multi-asset approach to real assets may be a more appropriate option for plan sponsors seeking to address inflation on the core menu.

State Street offers core menu investors a seasoned, diversified multi-asset strategy composed of a blend of commodities, TIPS, REITs, infrastructure, and natural resource equities. This multi-asset approach, featuring the diversification benefits of five distinct asset classes, allows the strategy to seek a positive real-return in excess of CPI over a full market cycle, similar to the long-term return expectations of a moderate balanced portfolio with a volatility profile in line with a longer-dated TIPS index.

Figure 5: State Street’s Real Asset Strategy Allocation

The Real Asset Strategy is expected to perform best during periods of increasing inflation or rising unexpected inflation. The strategy is meant to be a complement to traditional equity and bond assets, providing further diversification, attractive returns, and a source of income in a low-yielding environment.