Protect Eroding Nest Eggs

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Inflation has been subdued lately. The consumer price index (CPI) has been rising at an annual rate of about 1%. But plenty of economists worry that the Federal Reserve's policies will trigger a bout of inflation.

The Fed is currently printing more money, flooding the economy with cash. The pessimists say that as the economy recovers, the excess cash will push up demand for goods and boost prices. In the end, the Fed's policies could result in double-digit inflation, a level that was last seen in 1980.

Whether or not inflation spikes any time soon, it is worth taking precautions. Even a modest increase in the CPI can erode nest eggs, threatening retirement plans. To appreciate the problem, consider that over the long term, inflation has averaged 3% annually. At that rate, inflation can reduce a retiree's purchasing power by almost one third in a decade. To protect yourself, consider allocating at least a small portion of your holdings to investments that rise along with inflation.

Among the most reliable choices are Treasury Inflation-Protected Securities (TIPS). These bonds are issued by the Treasury. TIPS produce income in two ways. First, like any bond, they pay a fixed yield. In addition, the principal values of TIPS rise along with inflation. Say you invest $1,000 in TIPS, and inflation rises by 3%. At the end of the first year, the principal value of your investment would rise to $1,030.

Ten-year TIPS currently pay a fixed yield of 0.71%. That payout appears skimpy when it is compared with the yield of 10-year Treasuries, currently 2.95%. But if inflation surges, the principal value of TIPS will rise, while the principal of a conventional Treasury always remains the same. If inflation rises at an annual rate of more than 2.24% in the next ten years, then TIPS would outperform the Treasuries.

During the past five years, TIPS funds have returned 4.9% annually. But keep in mind that TIPS can suffer downturns. During the turmoil of 2008, many bonds sank into the red, and the average inflation-protected fund lost 4.1%. The losses occurred as panicked investors sold bonds to take shelter in conventional Treasuries. Still, TIPS can help to diversify portfolios because they can outperform ordinary bonds during periods of inflation.

You can buy TIPS directly from the Treasury. Many investors, however, may prefer holding mutual funds. The funds hold diversified baskets of TIPS, including securities of different maturities. In addition, the funds automatically reinvest interest payments, an important convenience for savers who seek to accumulate assets.

A strong performer is BlackRock Inflation Protected Bond Fund, which returned 6.1% annually during the past five years. During the downturn of 2008, BlackRock recorded a small gain, a strong showing in a year when most competitors suffered sizable losses.

BlackRock portfolio manager Brian Weinstein stayed afloat in the turmoil by selling some TIPS and putting 20% of assets in cash. When markets started to recover, Weinstein bought depressed TIPS and scored big gains as prices rebounded.

Another strong choice is Delaware Inflation Protected Bond Fund, which has returned 5.9% annually during the past five years. Portfolio manager Roger Early must keep at least 80% of assets in TIPS, but he can put the rest of his holdings in corporate bonds and foreign issues. He took advantage of the flexibility, buying depressed corporate bonds early in 2009 and scoring sizable gains when the markets revived. These days he is buying inflation-protected bonds from Australia and Brazil. Because inflation is already climbing in those countries, the principal value of the bonds should rise smartly.

Besides owning TIPS, investors who worry about inflation should also consider owning stocks of producers of commodities, including gold, oil, and coal. When the CPI climbs, prices of commodities may also climb. Frank Holmes, portfolio manager of U.S. Global Investors Global Resources Fund, argues that most investors should hold at least some gold stocks. He says that gold prices can climb during periods when most stocks and bonds are suffering.

Since 2004, gold prices have surged, climbing from $400 an ounce to more than $1,400. That has boosted profits of mining companies, which can produce an ounce of gold for $500 or less. Holmes recommends shares of Dundee Precious Metals, a Canadian miner, and Newmont Mining, a big U.S. producer.

Holmes argues that gold can continue climbing for the next several years. He says that demand from fast-growing markets in India and China will push up prices. In those countries, it is traditional to give gold jewelry as gifts for holidays. As the Asian economies grow, consumers are spending more on gifts. “As Chinese New Year approaches each year, there is a surge in demand, and gold prices strengthen,” Holmes says.

To hold a diversified basket of gold and other commodity companies, consider natural resources funds. A solid choice is Van Eck Global Hard Assets Fund, which has returned 13.6% annually during the past five years. Portfolio manager Carl Malan looks for solid companies that have the potential to grow for years. A favorite holding is Randgold, an African miner.

For a fund with a big stake in energy, consider Franklin Natural Resources, which has returned 9.6% annually during the past five years. These days the fund is buying oil-services companies, which provide the equipment and services needed for drilling and production. Holdings in the fund include Schlumberger and Halliburton.

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