THOUGHT LEADERSHIP

How TDFs can help combat inflation

Can target-date funds (TDFs) withstand increasing inflationary pressures? We believe so, all while providing long-term growth in excess of inflation.

Written by Michael Palazzi, CFA, CFP®

Since 2008, inflation has been a concern at various points in time. Think about when the Federal Reserve implemented its multiyear quantitative easing program, the European Central Bank followed suit several years later, and the Bank of Japan intervened in the bond markets. These events all led to concerns over inflationary pressure. Yet despite this unprecedented monetary stimulus, inflation has been stubbornly low, with central bankers unable to achieve even modest inflationary targets.

But with unemployment rates at multidecade lows, interest rates rising, and oil prices experiencing a comeback, the conversations are beginning to change. Clients are starting to ask whether TDFs are constructed to withstand higher rates of inflation.

Is inflation a risk today?

In the Vanguard Economic and Market Outlook for 2018: Rising Risks to the Status Quo, our Investment Strategy Group explains that one of the more pronounced risks coming into this year was a continually tightening labor market, which could lead to a higher-than-expected bounce in wage inflation. That could then cause the markets to reprice, signaling a more aggressive path for monetary policy normalization.

While the strength in the labor market may point to a cyclical uptick in inflation in the short term, we continue to believe that structural forces—in the form of technological disruption and shifting demographic trends—will help keep a lid on inflation over the medium to long term.

TDFs and inflationary pressures

It really helps to focus on the long term when you’re thinking about TDFs. That’s the approach we take at Vanguard because investors saving for retirement often have multidecade time horizons. This is why our Target Retirement Funds maintain significant commitments to stocks throughout an investor’s working career (ranging from 90% at the beginning of a career to 50% at age 65) and even well into retirement (30% for investors in retirement). We’re trying to provide investors long-term growth in excess of inflation.

When most investors think of inflation-hedging asset classes, stocks are not necessarily the first thing that comes to mind. However, while equities have very little correlation to inflation over the short term, they have served as a great inflation hedge for investors over the long term.

For instance, the S&P 500 Index returned 10.52% annually from January 1, 1970, through December 31, 2017, on average. Inflation, on the other hand, represented by the Consumer Price Index, grew at an average 4.10% annually during the same period. During the 47 years we cover below, equities did a good job offsetting the risk of inflation.

Data are based on rolling monthly average observations from the Bureau of Labor Statistics’ Consumer Price Index for All Urban Consumers and the S&P 500 Total Return Index, Morningstar, from January 1, 1970, through December 31, 2017.

Commodities as an inflation hedge

Commodities are often cited for their inflation-hedging properties. Our research indicates that commodities, in general, have exhibited a high correlation to unexpected inflationary shocks. What is less clear, however, is their long-term sensitivity and correlation to the broader rate of inflation (see the chart below).

The long-term risks investors face from inflationary pressure are real, and they are more acute for investors living in and nearing retirement, as their portfolios are generally more heavily invested in bonds. This is where explicit inflation-hedging allocations can make sense.

In our Target Retirement Funds, we include an allocation to short-term Treasury Inflation-Protected Securities (better known as TIPS) to provide investors with an age-appropriate level of inflation protection. In the more than two decades since TIPS were introduced in the United States, they have exhibited a stronger correlation to short-term changes in inflation, coupled with significantly less volatility than commodities.

Data are based on rolling monthly observations. We use the following indexes as asset class proxies: cash equivalents—Ibbotson U.S. 30-Day Treasury Bill from 1970 through 1977 and Citigroup 3-Month U.S. Treasury Bill from 1978 through 2017; TIPS—Barclays Capital U.S. Treasury Inflation Protected Securities from April 1997 through 2017; commodity futures—S&P GSCI Excess Return from 1970 through 2017; mining and energy stocks—Fama-French industry returns from 1970 through 2017; REITs—FTSE NAREIT Equity REIT from 1972 through 2017; international stocks—MSCI World  (USD); U.S. stocks—Standard & Poor’s 500 from 1970 through 1974; Dow Jones Wilshire 5000 Composite from 1975 through April 22, 2005; and MSCI US Broad Market thereafter through 2017; U.S. bonds—Citigroup High Grade from 1970 through 1972; Lehman Brothers Long-Term AA Corporate from 1973 through 1975; and Bloomberg Barclays U.S. Aggregate Bond from 1976 through 2017.

We define unexpected inflation as the difference between the 1-year annualized Consumer Price Index for All Urban Consumers and the Federal Reserve Bank of Atlanta Sticky CPI. We define expected inflation as the difference between the CPI and unexpected inflation.

Sources: Vanguard and mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#Research.

Target Retirement Funds: Built to manage risks

As we design portfolios that we believe can stand the test of time, we try to balance a number of risks investors face. Market risk, longevity risk, and inflation risk are all weighed in the process of designing, and continually vetting, our Target Retirement Fund construction.

We also focus on enduring investment principles like global diversification, transparency, and a low-cost approach. It’s qualities like these that we believe will serve every investor well over the long term.

About the author

Michael Palazzi, CFA, CFP®, is a senior DC investment strategist in Vanguard Defined Contribution Advisory Services. In his current role, Mr. Palazzi assists plan sponsors with analysis of plan lineup construction best practices and custom portfolio construction. Mr. Palazzi also has served as a product specialist across Vanguard’s suite of multiasset and taxable fixed income portfolios, where he supported the oversight and product management activities related to these funds. Mr. Palazzi earned a bachelor’s degree in finance and global business from Rider University. He is a member of the CFA Institute and CFA Society of Philadelphia.


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Notes:

  • For more information about Vanguard funds, visit vanguard.com or call 800-523-1036 to obtain a prospectus or, if available, a summary prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.

  • Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.
  • Diversification does not ensure a profit or protect against a loss.
  • All investing is subject to risk, including the possible loss of the money you invest.
  • Investments in Target Retirement Funds are subject to the risks of their underlying funds. The year in the fund name refers to the approximate year (the target date) when an investor in the fund would retire and leave the workforce. The fund will gradually shift its emphasis from more aggressive investments to more conservative ones based on its target date. An investment in a Target Retirement Fund is not guaranteed at any time, including on or after the target date.
  • The Vanguard Short-Term Inflation-Protected Securities Index Fund invests in bonds that are backed by the full faith and credit of the federal government and whose principal is adjusted periodically based on inflation. The fund is subject to interest rate risk because although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa. The fund’s quarterly income distributions are likely to fluctuate considerably more than the income distributions of a typical bond fund. Income fluctuations associated with changes in interest rates are expected to be low; however, income fluctuations associated with changes in inflation are expected to be high. Overall, investors can expect income fluctuations to be high for the fund.
  • Futures trading is speculative in nature and involves substantial risk of loss. Futures are not suitable for all investors.

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