Inflation was 12.5% in 1980, which seems incomprehensible considering it has been less than 3% every year for the past decade. Even though inflation has been low recently, there is always the possibility that it will spike again, even if it is due to unjustified market fears. Thankfully, there are ways to hedge against the negative effects of inflation.

TIPS protect your portfolio against inflation.

Traditional bonds do not protect against inflation surges - not even short-term bonds. For example, if you buy a $10,000 bond and inflation spikes by 4%, when the bond matures, that $10,000 will have the purchasing power of $9,600. Alternatively, if you purchase $10,000 in TIPS (Treasury Inflation-Protected Securities), when the bond proceeds come due you will receive $10,400 to account for the change in inflation, protecting your purchasing power.

TIPS were first issued in 1997 (the same year as the Roth IRA) because there was strong interest in an inflation-indexed product. They are still the only asset class that is directly linked to the the Consumer Price Index (CPI), the most common measurement for inflation. While nothing is completely risk-free, TIPS are considered extremely safe. Vanguard, Fidelity, and Schwab all integrate TIPS near or during retirement in their target-date funds.

When to consider hedging inflation risk in your portfolio.

Over the long-term, stock markets have shown to keep up with, or even outpace inflation. For that reason, it is not typically recommended that investors holding mostly stock (such as younger investors with no immediate plans to distribute from their portfolio) add a TIPS allocation.

People who are retired, or near retirement, are much more vulnerable to inflation shocks and should consider adding TIPS. These investors have a larger bond allocation (perhaps 40% or more) and they are consistently distributing from their portfolio. They need to hedge against inflation to protect their purchasing power and standard of living.

What is the ideal TIPS allocation?

There is no consensus for the percentage of TIPS that you should hold, just as you may receive different recommendations on the amount of stock and bonds you should have. It depends on who you ask for advice. “Vanguard’s approach to target-date funds”, discusses how they add short-term TIPS to their portfolios 5 years before retirement and continue to increase the percentage to a maximum of 17% of the portfolio at age 75 (which is 24% of the bonds and 31% of the domestic bonds). Their research shows that a short-term TIPS index fund does a good job of tracking inflation without the interest rate risk that is associated with longer-term TIPS. In my observation of a variety of target date funds and managed accounts, the TIPS allocation tends to range from about 10-30% of the total bond allocation. There are outliers, but that can give you a starting point to work with your advisor on the best allocation for your situation.

Get your portfolio ready for retirement.

Retirement is a big transition that exposes you to different risks. For those looking to preserve capital while keeping up with inflation, short-term TIPS are something you should consider. We can help you identify gaps in your investment portfolio and develop a plan to get you on track. Subscribe to stay in touch.

Linda Rogers, CFP®, EA, MSBA is the owner and founder of Planning Within Reach, LLC (PWR). Originally from New Jersey, Linda services clients throughout San Diego county and nationwide. She leads the design of PWR's investment portfolios which utilize broad, low-cost investments that integrate environmentally, socially, and governance (ESG) factors.

Planning Within Reach, LLC (PWR) is a fee-only and fiduciary wealth management firm offering one-time comprehensive financial planning, ongoing impact-focused investment management and tax preparation services in San Diego and nationwide. PWR is a woman-owned firm that specializes in busy professionals and impact investors. Planning Within Reach, LLC and their advisors do not receive commissions and do not hold any insurance licenses or brokerage relationships.