Inflation hasn't been a factor in the U.S. for years. The average inflation rate over the past 10 years has been around 1.7%. But the economy is approaching new territory as it looks to emerge from the pandemic. That new territory may include higher inflation, though the duration and severity of it is anybody's guess.
Officially, the Fed is targeting an inflation rate of just above 2%. Unofficially, some experts, including a former president of the Federal Reserve Bank of New York, worry it could be higher.
Inflation affects your retirement savings by offsetting your investment growth. If your IRA grows by 10% this year, for example, and inflation averages out to 3% for the year, your net growth is 7%.
A short period of higher-than-normal inflation won't ruin your retirement prospects, especially if you're young. But if you are older and already invested more conservatively, a longer bout of higher inflation is more problematic. You don't want to absorb 3% inflation when your investment growth is only 4% or 5%, for example.
To be clear, the Fed is not predicting runaway inflation this year. But if you are worried about higher prices and lower purchasing power in 2021, you can use these three exchange-traded funds (ETFs) as a layer of protection.
1. SPDR Portfolio TIPS ETF
TIPS are tied to the Consumer Price Index (CPI); when the CPI goes up, the principal value of TIPS rise, too. What's more, the interest income on TIPS is calculated by applying a fixed rate to the inflation-adjusted principal value. So as that principal value goes up, the income goes up too.
A declining CPI does reduce the value of TIPS. But you'll get the face amount at maturity even if it's more than the inflation-adjusted principal value.
You can buy TIPS directly to spare yourself the fees charged by the fund. But you may prefer the ETF for its simplicity. As a SPDR Portfolio TIPS shareholder, you gain exposure to various maturities in a single position. You also don't have to roll over matured TIPS, since the fund will manage that for you.
The ETF has an efficient gross expense ratio of 0.12%. Over the last 10 years, the fund has returned average annual growth of 3.79%.
2. Invesco DB Commodity Index Tracking Fund
A commodity position protects you from the effects of inflation because commodity prices tend to rise as inflation ramps up. You can invest in commodities directly (say, by buying gold bars and stashing them in your basement). You could also invest in companies that produce commodities, like U.S. Steel. But a mutual fund or ETF could provide exposure to a range of commodities in one position.
The Invesco DB Commodity Index Tracking Fund (DBC -0.59%) invests in futures contracts on 14 commodities, including gasoline, gold, copper, corn, soybeans, and natural gas. A futures contract is an agreement to buy the commodity at some future date for a specific price. This is a speculative approach, since the fund is betting on whether the commodity price will go up or down. Commodity ETFs are not for the faint of heart. Even for the hardiest of investors, this fund should make up only a small percentage of overall holdings.
The challenge with any commodity position is that it can do well in periods of high inflation, but it may not do you any favors the rest of the time. You can see this in the chart below, which shows the Invesco commodity ETF's performance history along with the U.S. inflation rate. The fund's average five-year returns are positive at 2.48%, but the 10-year average return is a negative 5.85%. Fees are high too, with an annual expense ratio of 0.88%.
3. iShares Gold Trust
The iShares Gold Trust (IAU -0.41%) buys and holds physical gold, with the goal of tracking the gold spot price. When you purchase shares, you are effectively buying ownership in those gold stores. This would be an alternative to a broader commodities position and a more convenient option than storing gold in your basement.
Like other commodities, gold can increase in value when inflation rises. But it has also performed well recently in the absence of inflation. In 2020, for example, gold rose 24% even as inflation was falling. Investors tend to move into gold when times are uncertain, be it from inflation or another reason. That might make gold a more versatile addition to your portfolio.
iShares Gold Trust charges expenses of 0.25%. Five-year average annual returns are about 12% and the 10-year average is about 2.7%.
Mild inflation is likely in 2021, as the population returns to spending money on vacations, dining out, and mall shopping. Whether that mild increase evolves into something more is a matter of debate.
If you don't want to take any chances, you can hedge against inflation with exposure to TIPS, a broad basket of commodities, or specifically gold. TIPS will be the safest choice among the three, but commodities could prove valuable if the market or the economy goes sideways later this year.