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Wednesday, 30 September 2009

4 low-risk inflation strategies

Margarette Burnette

Inflation should be a top concern for investors, especially among people facing retirement, says Michael Kresh, a Certified Financial Planner and author of "You Can Afford to Retire."

"When you are trying to accumulate money long-term, you have to try to beat the rate of inflation," Kresh says. "That means real (inflation-adjusted) growth in your portfolio, not just nominal growth."

The following are expert tips to help savers balance the desire for financial safety with the need to outpace inflation.

1. Strike balance between safety and return

Investors can easily protect themselves against the risk of loss of principal by choosing safe, low-yielding investments. However, that "safety" may be a mirage.

Parking money in such accounts makes it vulnerable to the risk of loss of purchasing power that comes with inflation, Kresh says.

4 inflation-fighting tactics

1. Strike balance between safety and return.
2. Add TIPS to list of possibilities.
3. Keep a sliver -- or more -- of stocks.
4. Stay the course?

"There's no way to get a real rate of return without taking some sort of financial risk," says Kresh.

Investors need to ask themselves how much risk they can take, says Neal Ringquist, president and chief operating officer of Advisor Software, a Lafayette, Calif.-based company that provides investment management software to advisers.

"I advise people to sit down and analyze their age, assets, liability and cash flow," Ringquist says. "Then they can define their goals and come up with a strategy to meet them."

The analysis helps people understand their capacity to bear risk. Investors who need 95 percent of their money just to meet minimum living expenses won't be able to take on as much risk as someone with a bigger cash cushion, says Ringquist.

2. Add TIPS to list of possibilities

Treasury Inflation-Protected Securities are low-risk Treasury bonds that guarantee a return that rises along with the inflation rate, as defined by the Consumer Price Index.

If inflation increases, so does the value of the TIPS investment.

TIPS are issued in five-, 10- and 20-year terms. They can be purchased through a broker or directly from the government through the TreasuryDirect Web site. An investor can buy up to $5 million in TIPS with a noncompetitive bid. More typically, these bonds can be purchased for as little as $100. They're also sold in $100 increments.

TIPS pay interest twice a year and the income is taxable.

Because TIPS increase in value every time inflation rises, there is some possibility an investor will incur taxable income from the security, Kresh says. In fact, bond holders are responsible for paying federal income taxes on the bond's appreciation in price even though they don't receive any actual income from the appreciation until the bond matures. This is commonly known as a "phantom income" problem.

Investors also can invest in TIPS through mutual funds or exhange-traded funds. One big advantage of purchasing TIPS through a fund is that funds pay out income in the form of a dividend, Kresh says. The fund owner still owes taxes, but does not have to wait to receive the income.

"If you're buying TIPS, it might be better to buy them in a fund simply because that income is distributed rather than having the growth in the bond," he says.

I bonds are another government-backed investment security that correlate with inflation. They can be purchased in increments as small as $25, but have a maximum purchase amount of $5,000.

"Since you can't accumulate a large savings with them, I bonds are really for smaller investors," says Kresh.

Current interest rates for TIPS and I bonds are very low -- zero percent in the case of I bonds -- just as they are with short-term Treasuries and short-term CDs, Kresh says.

"The difference is these bonds will pay the rate of inflation plus the interest that's promised in the bonds, so at least you know you'll have a real rate of return over time," he says.

Inflation-indexed bonds are investments that help people who are simply concerned about their savings, and are not necessarily worried about the market or trying to grow their net worth, he adds.

The values for TIPS and I bonds reset twice a year. Of course, the federal government fully backs TIPS and I bonds.

"It makes them a pretty safe investment," says Kresh.

3. Keep a sliver -- or more -- of stocks

Some investors may want to lower the amount of risk in their portfolio. But that doesn't mean they should shun equity investments entirely, says Richard Staszak, a financial adviser and estate planner in Pittsburgh.

Staszak advises retirees to put at least some of their money -- typically, cash they won't need for at least five years -- into stocks instead of traditionally low-yielding investments.

"If you have money that you don't plan to use for the next five to 10 years, why should you penalize yourself in an investment vehicle that pays only a half a point percent?" Staszak says.
“There's no way to get a real rate of return without taking some sort of financial risk.”

Bill Losey -- a Certified Financial Planner in Wilton, N.Y., and author of "Retire in a Weekend!" -- agrees.

"People are going to be living in retirement for 20 (to) 40 years," he says. "Even at an inflation rate of only 3 percent per year, you'd need to have about double your current income in 20 years just to maintain the same standard of living you have today."

Losey says that while there is no guarantee the market will perform as well as it has in the past, "the stock market has been the only place that has consistently delivered returns above inflation over a consistently long period of time."

Losey acknowledges that investors may need to keep some money in low-yield investments. But he adds that many people don't consider their long-term needs.

"Unfortunately, I'm seeing people who are panicking and taking all of their money out of the stock market," he says. "They're changing their entire investment philosophy to a 'preservation of capital' strategy.

"That's a real dumb move, and you can quote me on that."

Losey notes that he often meets people in their mid-to-late 70s who made similar mistakes in the past.

"They tell me, 'I retired 15 years ago and was defensive with my investments because I didn't want to take risks."

The result?

"They're blowing through their savings accounts and can't maintain their standard of living because their costs have increased," Losey says.

4. Stay the course?

Balancing concerns about inflation with worries over investment risk means different things to different people. While retired investors might take a cautious approach, it could be a different story for investors with a longer time horizon.

Younger investors should manage instability by building a stash of emergency cash and committing to invest a set amount of money consistently, says Larry Rosenthal, a Certified Financial Planner and president of Financial Planning Services in Manassas, Va.

"My advice is to get back to basics," he says. "Maintain adequate cash reserves and use dollar cost averaging for investing.

"When we have economic expansion, it can create volatility in stocks, especially if inflation increases. Younger investors can start dollar cost averaging now to limit volatility concerns."

Ringquist says investors should resist the urge to follow the investment crowd unless the move helps them reach financial targets. This is true regardless of whether the economic climate is unstable or calm.

"You have to ask yourself what is more important -- beating some index or achieving your retirement income objective," he says. "Returns on a portfolio are meaningless outside of the context of what your investments are doing to meet your goals."

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