Rising Inflation? Protect your Investments!

Throughout your career in the life sciences, you've been socking away money, whether it's into a 401(k), a 403(b), some other IRA, a college fund, or a house. That's good. Inflation, however, can be a wolf at the door. What can you do to protect yourself? Like hindsight, judging the impact of inflation on investments is 20/20, but by that point it's often too late. The only effective way to protect your investments is to defend your portfolio early, before inflation has a chance to wreak havoc. "In the mid 1960s, for instance, people didn't see inflation coming," says Anthony Ogorek, president of Ogorek Wealth Management in Buffalo, NY. But ready or not, it came, mercilessly ravaging unprotected investment portfolios in the years ahead by consuming large doses of purchasing power.

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Even a relatively mild dose of inflation dismissed as harmless can have significant long- term effects: As the years roll on, inflation's subtle bite incessantly erodes the value of paper assets such as cash, stocks, and bonds. Those at greatest risk are investors with long-term horizons, such as middle-age parents saving for retirement or building a nest egg for sending junior to college, says Mark Kaizerman, a financial advisor who runs Kaizerman & Associates in Natick, Mass.

Inflation averaged 2.7% a year for the 10 years leading up to the end of 2004, based on the US Department of Labor's consumer price index (CPI). What cost $1 in 1994 was priced at $1.27 last year; in other words, the dollar lost more than a quarter of its purchasing power in just 10 short years, and those 10 years were widely hailed as a period of low inflation.

Some believe that the next 20 years aren't likely to offer a repeat of the previous 20 when it comes to inflation. One reason is the view of some economists who say that the liabilities of the United States (Social Security and Medicare payments, for instance) are rising faster than the government's ability to pay them off without printing more money, which in turn fuels higher inflation. As the general population ages and puts increasing pressure on the government for social services, the pressure to inflate our way out of the financial challenge will be ever more tempting, argues Laurence Kotlikoff, an economics professor at Boston University and coauthor of The Coming Generational Storm (MIT Press, 2005).

Arguably, the future has already begun, and it doesn't look pretty. One of the smoking guns is the CPI itself. The widely monitored inflation index tracks general price trends for a number of goods and services, such as food, automobiles, and rent. In 2003, the CPI rose less than 2%. Fast forward to the October 2005 report and you'll find that consumer prices advanced at a 4.3% annual pace.

The government's numbers seem to agree with other possible predictors of rises in inflation. The price of gold, for instance, has climbed nearly 75% through the end of November from the end of 2001. The precious metal is considered the classic inflation hedge, and so its bull market sends a warning sign that investors are concerned about a future rise in the cost of living.

Commodity prices in general are also signaling higher inflation. The Commodities Research Bureau (CRB) Index is a widely quoted measure that tracks a broad mix of commodities such as corn, steel, and hogs. Since 2001, the CRB has climbed more than 64% through the end of November.

Investing in Treasury Inflation Protected Securities (TIPS) is one widely held defense against the risk of rising inflation. TIPS are issued by the United States Treasury, and so they come with the same assurances that back standard Treasury bonds. But, they also carry a bonus: TIPS hedge any inflation risk that otherwise might devalue a conventional Treasury bond's purchasing power.

The TIPS hedge draws power from a yield that adjusts with inflation. If inflation rises, so too does the TIPS yield, which is adjusted based on changes in the CPI. That compares with a conventional Treasury bond, whose yield is constant regardless of inflationary winds. Although a regular Treasury bond usually offers a higher yield over its TIPS counterpart, the premium comes at a price. Indeed, the standard-issue yield is set in stone for the life of the bond, which would be a losing proposition over time if inflation rises high enough and eats away at the purchasing power of the yield payments. TIPS, however, would keep pace, even though its yield started at a lower point.

Of course, if inflation declines, the conventional Treasury bond will likely prove the better investment over its inflation protected sibling. So the question of investing in TIPS and how much to invest often comes down to timing. Financial planner Richard Ferri, president of Portfolio Solutions in Troy, Mich., offers a simple rule of thumb that boils down to comparing yields on regular Treasuries vs. TIPS (interest rates statistics can be found at the Treasury's Web site, www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/index.html ). "I don't make guesstimates. I look at the markets and then choose the more attractive payout," says Ferri.

For example, when the yield premium, or spread, in regular Treasuries was approaching three percentage points over TIPS in late 2004 through the first half of 2005, Ferri says he was buying the conventional securities. At 2004'\s close, for instance, the conventional 20-year Treasury yield was 4.85% vs. 1.96% for the 20-year TIPS. The premium in standard Treasuries, he reasoned, was sufficient compensation against any future inflation threat. But when the spread narrowed to roughly two percentage points by late summer and early fall of 2005, he was selling regular Treasuries and buying TIPS.

Ferri says he maintains an ongoing allocation of TIPS in client portfolios of as much as 10%. How much of your investment portfolio is in TIPS?