Capitol Retirement Strategies · Episode #85: Inflation Rears It’s Ugly Head

Steve:

(music playing). All right. Welcome to Plan For Life Now episode number 85.

Dave:

Wow.

Steve:

Dave, we’re getting close to 100.

Dave:

We are. I’m wondering when we’re actually going to do these in-person again. I was actually thinking about saying to you, “Should we do one in-person?” But we’re just not there yet. You still got to get your kids… Are your kids vaccinated?

Steve:

They got their first shots. Well, my oldest is fully vaccinated, but my younger two, they got their first shots on Sunday.

Dave:

Excellent. How does it work for young kids? Is it a two shot regime similar to the other one with less dose or what?

Steve:

Yeah, I think it’s one third of the dose and it’s still a two shot regime three weeks apart. So they’ll get their second one right after Thanksgiving and be fully vaccinated shortly after that.

Dave:

All right.

Steve:

So this is what we’ve been waiting for. And the biggest deal for us, although these rules are constantly changing is once they’re fully vaccinated, even if there’s an exposure in one of their classes, they don’t have to quarantine, as long as they don’t have symptoms.

Dave:

That’s a big deal. That means a steady schedule going forward, I’m assuming.

Steve:

But we want to talk about the news that’s more important for most people out there listening today although I don’t think too many of our clients have young kids of the age getting vaccinated.

Dave:

They’re their grandchildren, so they’re not really their immediate problem.

Steve:

Yeah, exactly. But the more immediate problem, the more immediate headline, and this one just came out this morning is inflation. And the headline this morning, 6.2% inflation, the highest inflation rate that we’ve seen since 1990. And we’ve talked about this quite a bit. And in fact, as we were preparing to talk today, Dave, you said, “Hey, we should talk about inflation.” And I said, “Ah, haven’t we talked about inflation enough?” But you’re right, this is what we’re all worried about and concerned about and it’s front and center for most investors out there.

Dave:

Especially our investors who many of them are all in two groups, one is they’re going to be retiring within the next few years or whatever, very few, even more than the next few years, but retirement’s on the horizon or just as importantly, already retired and living on certainly not the income that they earned when they were working full-time, so I feel like it is a huge issue. I’ll start and then I’ll let you go. It’s interesting that we had the big raise in social security, but still not really keeping up with inflation.

Steve:

I was just going to mention that when I said, “Okay, 6.2.” Just to go back a couple weeks ago, a social security announced a 5.9% increase in inflation or cost of living adjustment, which sounded nice at the time, but now you say 6.2 and you go, “Nah, it’s a little bit short. That’s not quite keeping pace there.”

Dave:

Yeah, but still, if they had done what would seemingly be high at 4% and then this news came out, that would be a bigger problem, but still that’s how intense this inflation is right now.

Steve:

Yeah, that is and not to digress too long on this, but this is one of those things that we’ve talked about before is having a pension or having social security that does have a cost of living adjustment, but just isn’t quite the cost of living adjustment that you’re actually experiencing or the rate of inflation. And this is true with certain federal pensions.

Steve:

We’ve talked about how the FURS pension, by design it’s set at whatever the CPI is minus 1%. So if you’re a person who has social security, okay, you’re lagging behind a little bit. You’ve got a first pension where you’re going to lag behind by about 1% there and that’s not a big deal in any one year, but you do that for five or 10 years, obviously that can start to add up.

Dave:

Right. And here’s anecdotal inflation, so I’m reading these headlines this morning. And then my wife does not start with the newspaper, she starts with shopping. So she’s shopping. And she’s telling me, she’s looking at, I guess, some winter stuff, sweaters and things. And she’s saying, “I’m willing to pay good money for a decent sweater, it’s just that these sweaters, they’re charging so much but they’re not decent.”

Dave:

They’re like, and she knows this stuff way better than I do. I’m not an expert at what’s even cheap and what’s not cheap in the world of shopping for sweaters, but she knows. And that’s inflation, even things that are your basic goods. Things like getting up in the morning and you’re doing some internet shopping and you can’t even believe the prices for something that last year were so much less really adds up in your actual real world living budget.

Steve:

Well, and that’s something I don’t have any of this data right in front of me, but I know I’ve read this about how different ways inflation manifests itself. The obvious one is it costs you however much to buy a loaf of bread, now it costs you 6% more. But the other way is in that loaf of bread now, they’re including fewer slices. It’s a smaller loaf of bread maybe for the same price. Or take your wife’s example, in Julie’s case she’s getting a lower quality sweater maybe for the same price or a little bit more.

Steve:

I mean, those are different secret ways, I shouldn’t say secret, more subtle ways that inflation can manifest itself. So of course, just going back to the headline, 6.2% inflation from a year ago, the interesting thing to me was the breakdown in where you saw inflation. So you saw fuel oil prices up 12.3%, energy prices, well, I should say that was how much was reflected in inflation.

Steve:

We’ve talked about this before, about how there are certain categories of inflation that are averaged in over time and fuel happens to be one of them where it says here, 59% increase in fuel oil prices over the last year, but they don’t include all 59% in one year, they just include that 12.3%. Used car prices up 26% over the last year. New car prices up, but not nearly as much.

Steve:

Food prices up 5.3%, certain categories up almost 12%. I mean, across the board, we’ve all felt it, we’ve all seen it. We’ve certainly seen this much higher inflation. Now, as I was doing some reading on this preparing for this talk here, I read into a term that I’d never seen this one before and Dave, tell me if you’ve seen this before, have you seen this comparison of sticky inflation versus flexible inflation?

Dave:

Like you, I’ve just read it the last couple days. But honestly, you’ve just read it more recently than I have, but I get the impression that sticky inflation is basically, we had this talk in a different podcast where I think it might have been me, I don’t remember which one of us, but we were talking about how these prices have gone up, but they’re not like, I think this was me, my theory is they’re just not coming down. I think that’s sticky inflation, but I read this several days ago. So update me on that.

Steve:

Well, the definition here on sticky inflation includes categories like rent, insurance costs, medical expenses, they tend to exhibit longer staying power. So that might go along with if you get a rent increase, they’re not going to come back to you the next month and say, “Yeah, we’re going to give you a rent decrease here. Yeah, we think we’re going to change these things down,” versus the flexible inflation are typically more commodity based things.

Steve:

And the example that I was reading here had to do with lumber and copper and soybeans. So great example, if you remember over the summertime, springtime into summertime, everyone was talking about how insane lumber prices were. Our next door neighbors, they moved a couple streets over and they wanted to build a screened in porch on their new house and it was just insane how high lumber prices were. Well, as of April, lumber was up 120% from the prior year, just crazy.

Steve:

Now here we are, end of September, and lumber was quote unquote, only up 20% year over year. So the point is that there are certain categories where you’re going to see these wild fluctuations in there, but they could come down and then like you said, you’re going to see other categories like rent or those kind of costs where if they go up, they might not go up as dramatically, but they’re not going to come down all of a sudden, it’s not like that’s going to happen.

Dave:

Yeah. So I’m going to shift this to now, what do we do about it? What do we do about it? I don’t know what you out there listening do about it because a lot of you are our clients. So what are you guys doing about it? I feel like this is like everything else, COVID related, an accelerant of what was happening anyway, but now in retirement planning. So we’ve always worked on, you and I have a basic philosophy that we’ve had since we started working together on this however many years ago and that is income comes first.

Dave:

We got to deal with your retirement income and make sure you have enough coming in every month and that has to grow per inflation. So that’s been our premise since we started, no matter what we do, we focus on it. And quite frankly, in low inflation, we’ve had low inflation decade or whatever. Okay, people say, “Yeah, I get.”

Dave:

And people are still concerned about, our clients are still concerned, I’m not telling you people disagreed with us, but now you see why we need to push that because you never know when real inflation was going to happen, now it’s happened is one of the reasons I wanted to talk about this day, it’s official, it’s happened and you have to have enough retirement income.

Dave:

If you err on the side, and this is how I feel like it is going forward. If you err on the side of planning to have too much retirement income not guaranteed to come in monthly, that’s better than erring on the side of not enough.

Steve:

Oh, absolutely. And I 100% agree with you. I feel like this discussion that we’ve had with clients of, “Okay, well, we’ve got to have this ability to produce this guaranteed income and grow this over time,” they might have nodded their heads and say, “Oh yeah, we definitely need to grow that.” But frankly, when you’re barely touching 2% inflation, that doesn’t really feel like a real risk. Yeah, I know conceptually, I should worry about that, but inflation’s been so low. I’m not too concerned about it.

Steve:

I mean, just to bring this down even to specifics, when we work with people on structuring annuities and products like that, to generate this guaranteed income, we need things that can grow or have some sort of inflation adjustment built into the product so that we can go up. Maybe it didn’t seem like a big deal if your inflation or if your income stayed flat for the last seven or eight years, but now when inflation starts to kick up and if it’s, let’s say it’s 6% for the next three years, that’s certainly possible and that’s not by any means catastrophic, but all of a sudden, if you’re income hasn’t gone anywhere, you’ve fallen behind.

Dave:

Right. And then my other point about this is as we get into this, it’s sort of what you’re alluding to, part of this is not… When it comes to income planning for retirement, it’s just not for amateurs. I know people say, “I can do it. Why should I pay you guys?” You guys would be the entire industry, I’m not just talking about you and me. Why should I pay you guys when the market’s going up and I could just do all this myself?

Dave:

Well, one of the reasons you pay professionals to do this work is because carving out an income strategy with your assets and making sure you still have liquidity and everything that’s involved in that. And then the scope of the products that are out there and picking the right ones for you and administering it the right way, not just when you do it, but as the years go on is not for an amateur.

Dave:

It’s just not for people whose profession is not this, which we’ve always said there’s a difference in clients we work with who have huge pensions whose income need is non-existent. And those pensions are index for inflation versus clients who rely only on maybe a small pension in social security or just social security.

Steve:

Yeah, totally different planning, outlook and philosophy there. So let’s have this discussion that everyone loves to have about, “Okay, so we see inflation coming, what are the best hedges against inflation?” As I was writing this down, I had to start off by saying, first of all, and if you know our philosophy at all, you know that we hold broadly diversified portfolios and we’re not ever attempting to make these big bets on, “Okay, I think inflation is coming, so we’re going to shift all of your assets into X, Y, Z categories.”

Steve:

And I might have told this story before, I had a client that probably became a client in 2004, 2005, somewhere in that timeframe. And I looked at their portfolio coming over from another advisor and he had all of their money in healthcare stocks, financial stocks and something else, but his basic idea was, “Okay, baby boomers are getting older, they’re going to need more healthcare and they’re going to need more banking service,” or something like that. And he had taken all of their money and bet on this big, broad idea.

Steve:

And maybe he would’ve been right over a real long time period, but it’s risky to bet on any one particular outcome and to go too far in on this idea, even if it is an idea that I think most people would agree, we’re going to have a couple years of inflation here. So I want to start with that, that I don’t think that anyone should be taking all their money out of a broadly diversified portfolio and saying, “Okay, I’m betting on inflation. I’m going to go all in on this. This is really where my money needs to be.”

Steve:

Now that said, the common discussion around inflation will start with these couple of assets, treasury inflation protected securities, commodities, throw in there gold and precious metals and real estate. So if you want to go out and Google, “Okay, how do I hedge myself against inflation and whatever stock financial articles are out there,” they’re probably going to mention some form of those things in there. And not without some reason. I mean, those things are historically good inflation hedges, but here’s my problem with a portion of it.

Steve:

First of all, if you take a look at tips right now and tips, if you don’t know are treasury inflation protected securities, tips are bonds issued by the federal government that will pay higher interest if inflation picks up. So if we had inflation at 10%, they’re going to pay a much higher interest rate than if inflation is at 2%. And that’s great, that obviously is a hedge against inflation, but the problem is that everybody else out there knows this in addition to you knowing this or me knowing this. And the rates of return that you’re going to get on these things, if inflation is 6%, you might right now on a five year tip, you might get maybe 1.5% rate of return on that. So the problem is that it’s already priced in so much.

Dave:

If that’s the case, they should change the name of the investment, quite frankly.

Steve:

Well, I mean, they are treasury inflation protected. So I mean, you can’t get any other bond instrument where they’re going to pay you a rate of return based on inflation. So it’s a pretty unique investment vehicle in the investment world, but you have-

Dave:

That’s not keeping up with inflation.

Steve:

Yeah. I mean, you’ve got to think of it in terms, “Okay, what am I paying for the asset? If people already expect a lot of inflation, they might have bid up these prices higher than is even reasonable.” And we always have this discussion around commodities. First of all, you can’t throw commodities in there just as this lump some asset commodities can be gold, commodities can be oil, timber, and they can move in drastically different directions and they can be very, very volatile.

Steve:

Just one of my classic talking points is gold is about twice as risky as investing in stocks when you look at the volatility. So could gold be a good hedge? Yeah, but think of it as the riskiest thing in your portfolio. Think of whatever small cap technology stock that you think is really risky, gold is probably riskier than that. So you’ve got to think of it in those contexts.

Steve:

And this is always the answer when people come to us and say, “Okay, I want to hedge against inflation. What’s the best way for me to hedge against inflation?” We’ve talked about these stock answers and the data, the statistics tell us that the best hedge against inflation is having stocks in your portfolio. So over the long term, stocks have given you the best inflation adjusted returns. Now, I took a look at some of this data here that breaks down the returns in stocks by the rates of inflation that we’ve experienced.

Steve:

This is for U.S. stocks over the past 50 years or so. And basically what it shows us is that you get positive, really good returns in stocks, anywhere from 10 to 14% when inflation is anywhere from zero to 6%. When you start to go above those extremes, so you either have negative inflation, basically when we’re in a recession, something like that or you start to go above 6%, which we’re creeping towards, or we’re actually over that a little bit, that’s really where you start to see, “Okay, we have some deterioration in the returns of stocks there,” but it’s still your best bet compared to any other asset class that’s out there.

Dave:

Right. Not to mention even if during the highest inflationary times maybe your stock portfolio is not doing as well, the portfolio itself is based on money you need for the future. Get out of the highest inflation times, it goes up again, ultimately keeping up with your inflationary need as you start to tap into that money 10 years later.

Steve:

Yep. And I know this is not always the most satisfying for people to say, “Okay, we’re maintaining this broadly diversified portfolio, we’ve got, stepping back from the current situation we’re planning for. If the market were to decline, if we have sustained inflation, we’ve got a good balance between bonds and stocks and real estate.

Steve:

You’ve got a good base of guaranteed income, but those are the things that we can control. I can’t control if inflation is going to be 6% or 8% or 2%, that’s beyond our control. What we can control is how we’re allocated. And I think going too granular on, “Oh my gosh, we should be in consumer staple products instead of being in cyclical, durable goods and blah, blah, blah,” I don’t think there’s any real value to that.

Dave:

Yeah. You know what, I look at it as an analogy of a football. So we’re like the coach and we happen to have a great quarterback and that great quarterback is a diversified stock portfolio managed the right way over a long period of time. That player for us was like Aaron Rogers, but now because no, it’s like Tom Brady. So basically we have Tom Brady, you need a Tom Brady to be great. So as the coach, what’s the best way to utilize that player for different situations? And that’s how we utilize that player for inflation.

Steve:

Right. All right. Good stuff. I hope everybody is staying safe out there, staying healthy and we’ll check in again next month. (music playing).