It’s been difficult to get an accurate read on U.S. inflation. The Consumer Price Index rose 0.4 percent in April, versus a forecast 0.3 percent. That is a sizable increase over March’s 0.1 percent increase. Annualized, core price growth has actually been moderating, dropping from 2.3 percent in February to 2.1 percent in April.
Yet it appears the deep rout in the price of oil is behind us, and higher commodity prices together with tightening labor markets means inflationary pressures are likely to increase by later this year; on the other hand, we have heard the argument that “inflation is just around the corner” for so long, it’s easy to be skeptical. So is it a prudent time to start suggesting that your defined contribution (DC) plan sponsors consider an inflation hedge option for participants?
Multiple asset classes claim to offer inflation protection, including commodities, dividend stocks and real estate investment trusts, for example. But for near-retirees and retirees, Treasury Inflation-Protected Securities (TIPs), which come with coupons tied to the rate of price growth, can provide the best inflation hedge, says Dan Shackelford, CFA, vice president and portfolio manager with T. Rowe Price Group, Inc. in Baltimore. TIPs’ returns, particularly short-term TIPs, have a high, immediate correlation with unexpected jumps in inflation, he notes, while other asset classes can take longer to respond and are often more volatile.
TIPs’ suitability depends on the plan participants’ profile: The securities work best for pre-retirees and retirees. Jake Tshudy, director of defined contribution investment strategies with SEI, points to a construction company’s plan: Because of the work’s physical stress, the average participant retirement age was 57. Consequently, SEI designed a glide path that introduced TIPs into the portfolio earlier instead of waiting until participants reached age 60 or 65.
A participant’s overall asset allocation also matters, says Shackelford, who views inflation as a portfolio risk factor. In a portfolio 100 percent invested in bonds, for instance, there is very little hedging ability against inflation. “You have to start with the idea, first of all, how damaging would higher inflation be to my investment plan?” he says. “And then, try to get a sense for how much of a mitigating factor are the current investments that I have.”
How to Include?
DC plans can include TIPs funds as part of the investment menu or through a target date fund (TDF). T. Rowe Price offers two TIPs funds for participants; one fund is benchmarked off the broader TIPs index and its holdings average a seven- to eight-year maturity, and about five years ago the firm launched a shorter-duration fund. Vanguard also offers two funds in its DC plans and target date plans. The longer duration fund has $23 billion in assets while the shorter duration fund has $5.3 billion, according to Matthew Brancato, CFA, CPA, department head in Vanguard Institutional Investor Group in Malvern, Pennsylvania.
Tshudy believes TIPs should be part of a TDF to avoid potential misuse by participants. “We find that it’s best included with a professional oversight target date fund where we can monitor and adjust the exposure and apply it when it’s best,” he says. “As a core menu offering, there’s a chance that you could have younger people, 25-year-olds, for instance, who would use this as an investment option when it really is not relevant to their purpose.”
Low Adoption Rates
Sponsors and participants haven’t been flocking to either format, however. Brancato reports that 33 percent of Vanguard’s DC-plan clients offer a TIPs product, but only 4 percent of participants use the funds. Within Vanguard’s TDFs, TIPs options are concentrated in the shorter-dated funds aimed primarily at pre-retirees and retirees. Because they’re concentrated in just a portion of the target date funds, they don’t necessarily add up to a significant portion of the overall asset base, he says.
Shackelford characterizes recent demand for T. Rowe Price’s TIPs funds as “somewhat lackluster,” but that result doesn’t surprise him. Since 2008 inflation has been tame and there haven’t been many events that could cause it to unexpectedly spike higher. The collapse of energy prices in 2014 and 2015 reinforced the low-inflation mindset, he adds.
Focus on Risk Management
From a consultant’s perspective, a significant current challenge to recommending TIPs’ inclusion in a DC plan is that the bonds’ real yields are currently very low (or negative for the five- and seven-year bonds as of mid-May). This “makes them less attractive than they would normally be in an environment where you have the central banks doing everything possible to try to increase inflation,” says Shackelford.
Tshudy believes consultants can help sponsors work around this “return-only consideration mentality” by focusing more strategically on TIPs as a long-term inflation hedge. TIPs are a risk control, he argues, and there are times when their returns may lag. Brancato supports that case: “I actually don’t think that it makes sense to include TIPs because of any return expectations but rather because the movement of the TIPs’ returns will correlate with purchasing power needs for retirees.”