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Inflation actively erodes purchasing power over time, which means retirement savers need to incorporate tactics for beating inflation as they build their nest eggs.
When it comes to beating inflation, the best advice is to work smarter, not harder. Some of the most effective defenses are passive strategies you can establish and automate. Here are some of the most efficient ways you can stay ahead of price increases.
1. Treasury inflation-protected securities (TIPS)
Treasury Inflation-Protected Securities (TIPS) are Treasury bonds that peg their value to the consumer price index in order to maintain their “real” value. This means that the twice-yearly interest payments these bonds pay also adjust, since they’re based on the inflation-adjusted principal.
Even if inflation would erode the purchasing power of a standard bond, the adjustable nature of TIPS preserves your principal investment. When the bond matures, you’ll receive either your original principal or an inflation-adjusted amount depending on which of the two is higher.
You can opt for a low-cost TIPS exchange-traded fund (ETF) if you want inflation protection without having to buy Treasurys yourself.
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2. The pricing power test
Inflation forces companies to pay more for the materials, components and labor to produce their products. Unless they can raise their prices to compensate, this erodes profit margins. For investors, this can hurt the value of the stock as well as lower the dividends they might otherwise expect to earn.
Businesses with strong pricing power are ones that have inelastic demand — that is, people will likely buy them even if the price rises. Sectors such as consumer staples along with certain areas of the technology and infrastructure industries enjoy pricing power to pass along their increasing costs.
Invest in companies that offer goods or services people need to buy to protect yourself from inflation. You can get broad exposure to companies with pricing power by investing in ETFs that focus on these sectors.
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3. Automated dividend reinvestment
Even in periods of high inflation, dividend growth often manages to outpace that inflation. Put those returns to work for you via automatic reinvestment. Called a dividend reinvestment plan (DRIP), this tactic involves using dividends to automatically invest in additional whole or fractional shares.
Make sure your income-generating funds are set up to reinvest dividends so you can effortlessly compound your gains and keep ahead of inflation. Most brokerages and retirement plan providers make it easy to establish a DRIP. When you log in, look for an option to reinvest dividends across your portfolio or enable it for each individual fund, depending on how yours is administered.
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4. CD Ladder
To combat inflation, the Federal Reserve raises interest rates. While this can be painful for borrowers, there is a silver lining for savers: higher interest rates on various types of savings products.
Store your money in high-interest certificates of deposit (CDs), which give you a fixed, guaranteed interest rate in exchange for locking up your money until maturity.
A CD ladder delivers the best combination of yield, Federal Deposit Insurance Corporation (FDIC) protection and flexibility. Build one by opening a series of CDs with maturity terms at regular intervals. Staggering rollover dates ensures that you’ll have quick access to at least some of your emergency money while still earning an inflation-beating yield.
