Built for these times: LifePath® and inflation

Jun 30, 2023
  • BlackRock

Living with inflation. Read on to learn more about how LifePath target date funds are built to navigate the current inflationary environment.

Inflation has always been a lurking concern for retirement savers because it raises the uncomfortable prospect of potentially outliving one’s savings or having to change how you spend in retirement. For the past three decades, inflation in the U.S. has hovered around 2%. While inflation has slowed from its sharp spike in 2022, it remains stubbornly above central bank targets.1

With the Consumer Price Index having jumped to an annual rate of 6.4% in January, it's no surprise inflation is still making headlines.2 But one headline is conspicuously absent: Retirement investors can turn to target date funds to mitigate inflation risk.

At BlackRock, this concept is central to our investment philosophy. We began thinking about this problem when we pioneered the target date fund in 1993 and have been evolving it ever since. These age-based, asset allocation funds gradually become more conservative as participants near retirement, and are designed with inflation in mind. These findings led us to update our LifePath model to deliberately incorporate an inflation glidepath into our investment framework in 2019.

In the sections that follow, we aim to provide clarity on the driving forces of inflation today and demonstrate how LifePath is built to address them.

What’s driving inflation this time?

A balanced amount of inflation encourages healthy economic growth. If there’s too little, people delay their planned purchases in anticipation of lower prices. If it’s too high, prices rise faster than consumers can keep up with, which inevitably leads to demand falling and the economy slowing down. This is what our central bank and others around the world are carefully deliberating today: How much do they need to raise interest rates? If they go too far, they risk a premature slowdown; and if they do too little, they risk potentially exacerbating inflationary dynamics.

Much was written last year about inflation being driven by supply chain issues, further complicated by the asynchronous restart to the world’s economies. During the pandemic, and subsequent post-lockdown recoveries, the divergence between strong demand for goods and weak demand for services was stark. However, whilst goods inflation appears to have fallen back to more normal levels, services inflation remains at elevated levels. Demographics seems to be at play here with labor shortages fueling wage growth in Developed Market services sectors. A tight labor market is not likely to ease by itself anytime soon. That means inflation could remain above central bank targets for even longer than they expect.

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What does this mean for retirement investors?

In the context of investing for retirement, we analyse the impact of inflation on wage growth and asset class performance.

Typically, wages outpace inflation. Since 2000, wage growth has been higher than inflation 65% of the time, and wage growth (across multiple metrics) has never had a negative 12-month period. While recent real earnings reports have indicated that wages are trailing inflation, LifePath’s asset allocation accounts for these short-term anomalies.

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BlackRock’s research shows that most asset classes will provide returns equal to or above the inflation rate, given a sufficiently long investment horizon. However, some do a better job diversifying a broad portfolio in periods when inflation is high, or when inflation rates exceed levels that were anticipated. Our approach to incorporating inflation-sensitive asset classes is rooted in understanding the nuanced ways that inflation can affect a portfolio in different economic regimes.

Commodities are a capital-efficient hedge for short-inflation shocks and are highly responsive to short-term changes in inflation. TIPS provide an effective inflation hedge over the medium-term, especially as it relates to fixed income, as their price and coupon payments are directly indexed to changes in CPI whereas traditional ‘nominal’ bonds are not. If inflation is higher than nominal interest rates, traditional bond returns will not keep pace with the rising cost of living. Real Estate’s inflation protection is unique in its ability to pass through increases in rents as well as through capital appreciation. These two components diversify traditional equity risk over the longer-term, while also providing inflation protection in the shorter-term.

There is no ‘silver bullet’ to defend a portfolio against inflation. Its effects can show up in different ways, and over varied time periods. We deliberately account for these scenarios within LifePath. TIPS, Real Estate, and Commodities each have their own unique properties and therefore differ regarding their responsiveness to inflation. A broad portfolio becomes more adept in diversifying the risks inflation can pose when combined in optimal amounts across the lifecycle.

Inflation sensitivity varies by asset class

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Source: Morningstar Direct data as of 31 December 2022. Beta measurements are taken from common inception dates of the three indices shown above since 1 March 2005. Inflation is represented by the IA SBBI US Inflation Index. Past performance is not a reliable indicator of future results. Beta is measured against the IA SBBI US Inflation index, which is a US CPI proxy created by Ibbotson.

LifePath holds allocations to these asset classes – in optimal amounts for investors at all stages of their journey, as the impact of inflation is felt differently depending on your age. The need for short-term inflation sensitive assets for individuals in the early-to mid-career is quite low, given their long investment horizon and relatively high equity allocation. Conversely, those nearing retirement require more, as the transition from spending their wages to spending from retirement savings draws nearer.

In the past year, inflation hedging asset classes like Commodities and Real Estate have returned 16.1% and -25.1% respectively, against a year of persistent and high levels of elevated inflation. While all asset classes posted negative returns (with the exception of commodities), TIPS outperformed the Bloomberg U.S. Aggregate bond index (-11.9% vs. -13.0%) as of 2022 year-end.

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Source: Bloomberg as of 31 December 2022. 1 Based on annual average percent change from previous year. All returns are cumulative for the time periods shown. “REITs” represented by the FTSE/EPRA NAREIT Developed TR USD index, “Commodities” represented by Bloomberg Commodity Index, “TIPS” represented by Bloomberg US Treasury TIPS Index, “1-5 Year TIPS” represented by the FTSE US Inflation Linked Securities 1-5yr Index, “Global Equities” represented by the MSCI World NR Index, “US Bonds” by the Bloomberg US Aggregate Bond Index TR. All “End” dates reflect data as of 12/31 of each respective year. Past performance not indicative of future results. Index data provided for illustrative purposes only. Indexes are unmanaged and it is not possible to invest directly in an index.

The bottom line:

The million-dollar question, of course, is what happens next? Will inflation prove transitory or more permanent? No one knows. But the bottom line is: How it affects someone’s retirement savings depends largely on where they are in life, and how they react to it.

Younger investors, who have longer investment horizons and greater equity allocations, are less impacted by short-term spikes in inflation. Meanwhile, investors closer to retirement benefit from LifePath’s inflation-sensitive assets.

Given the prominent role that a target date fund plays within the participant’s retirement journey, it’s paramount that plan sponsors pay close attention to the underlying asset allocation. In the long run, the benefit of having compounded contributions over a full lifecycle will yield better participant outcomes.