How Inflation Adjusted Investments WorkPosted: January 10, 2012
Inflation is something that most investors will not think about before it is too late. Unfortunately inflation can destroy the value of almost any investment and turn potential returns into losses. Inflation-adjusted investments are designed to preserve value.
How Inflation Destroys Investments
Inflation’s affect on investments can be devastating. Take the case of a bond that pays 3% interest, if the rate of inflation is 4% the bondholder actually loses 1% of the bond’s value. If the inflationary period continues for ten years the holder would lose 10% of the bond’s value.
Even though the rate of inflation in the US is quite low right now it can go up. In 1972 the US inflationary rate was 3.25% but by 1980 it had risen to 13.5%. That meant the inflation rate was ten times the standard interest rate on vehicles such as bank accounts. This was not even the highest inflation in US history, in 1946 inflation hit 19%.
Everybody needs to have at least a few inflation-adjusted investments to protect his or her investments. There is no guarantee that high inflation will not return at some point and destroy your investments. Such vehicles are a good insurance policy against this scourge.
Adjustable Rates and Principals vs. Inflation
The most common inflation-fighting mechanism is an adjustable interest rate. The interest rate changes to match the rate of inflation that stops an investor from losing value when the value of money falls.
A popular investment that employs an adjustable rate is TIPS or Treasury Inflation Protected Securities issued by the US government. TIPS pay interest on an inflation-adjusted principal so they never lose value. In this arrangement the value of the bond is based on the current rate of inflation not the purchase amount. A big advantage to these securities is that you can purchase them directly from the Treasury.
There are also inflation-adjusted municipal bonds. These use a similar mechanism to adjust the value or the interest rate to compensate for the erosion of value. The Treasury also issues a class of inflation adjusted bonds called I bonds.
Other Inflation Fighters
Another popular means of compensating for inflation is an indexed investment. In this arrangement a portion of the investment is placed in an index of stocks. Since the stock market usually increases in value at a rate that is much higher than the rate of inflation it will make up for most losses.
Indexed annuities and indexed insurance policies are designed to prevent the loss of insured investment income in inflationary periods. Fixed annuities in particular can be very vulnerable to rising rates. The typical indexed annuity combines an index and a fixed-annuity to guarantee income.
Some indexed annuities even offer a guaranteed rate of return. Under this mechanism the return remains at the highest level even if the market falls. This locks in higher returns to compensate for inflation.
How to Use Inflation Adjusted Investments
The average person should have at least 10% of his or her retirement investments in some sort of inflation-adjusted vehicle. This should compensate for normal inflation. In an inflationary period it is often a good idea to transfer a large percentage of your money into adjusted vehicles.